RegulationJul 25 2014

FCA sounds warning over bond fund ‘risks’

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Consumers have been warned over a number of risks with certain bond funds including potential liquidity issues as a result of diminished trading activity and the negative impact on pricing of a looming interest rate rise, in a notice issued today (25 July) by the City watchdog.

The alert is targeted at investors or prospective investors in corporate bond funds, which buy and sell debt securities issued by private companies.

Specifically, the Financial Conduct Authority states that while such funds typically have a bias towards “low-risk categories of corporate bond securities” which make up, it says, around 80 per cent of most portfolios, they are “not completely risk free”.

It hints at poor consumer understanding of the machinations and risk and return characteristics of the funds and, importantly for advisers, tells consumers that are “having difficulty understanding corporate bond funds” to “seek professional advice”.

In terms of specific issues, the the FCA notes that it could be “hard to sell holdings in corporate bond funds” because of low trading activity in underlying markets, which it says in any case have shrunk in recent years.

The alert states: “Fund managers manage this risk for you, by monitoring the values that can be bought and sold in each bond and limiting the size of funds’ holdings in any one bond. Most of the time fund managers ensure that investors are able to buy and sell their units on any day.

“However, in very extreme market conditions fund managers could become unable to sell sufficient quantities of bond holdings to fulfil redemption orders, leaving investors unable to sell fund units.”

The FCA also warns over a future rise in interest rates, explaining that as interest rates rise bond prices fall. Given predictions that the Bank of England will move rates either later this year or early next, this is something that is going to shortly become more pressing.

Finally, the FCA warns that while most securities are safe funds are exposed to risks related to defaults by the underlying companies issuing the bonds.

The alert says: “Company defaults can impact the level of returns generated by the funds. An unexpected default reduces income and the capital value of a bond holding. Also, market expectations about economic conditions and the likely number of corporate defaults drive bond and fund prices.”

The FCA also gives investors a five-point list detailing considerations before investing in a fund, including assessing the return against investment objectives, understanding the risks, and ensuring “you can financially withstand a dall in the value of your units.”

It also emphasises the liquidity concern, stating that investors should “consider whether you need to be able to take your money out quickly”.