Fitch: Liquidity mismatch highlights risks

In a special report on bond fund liquidity provision, Fitch Ratings said daily dealing had become “the lifeblood of the industry” and appeared to be particularly common among vehicles dealing in less-liquid areas.

The ratings agency estimated that 94 per cent of Irish and Luxembourg Ucits bond funds offered daily dealing, with this number rising to 96 per cent for high-yield funds and 98 per cent for emerging market debt portfolios.

“Funds may be challenged to meet this market convention in less-liquid asset classes in periods of stress,” analysts Alistair Sewell and Roger Merritt wrote.

Fitch acknowledged that the typical high-yield portfolio tended to hold more cash than investment-grade funds, but also warned that this was not the case across the board.

“Some high-yield funds hold considerably lower cash balances than the average for investment-grade funds,” Mr Sewell said in a separate update.

The senior director at Fitch also cautioned that fund flows had become increasingly volatile, with recent trends meaning a greater redemption risk for junk bond products.

“Flows in European high-yield funds vary considerably more than investment-grade funds and the difference is rising – reaching a two-year high – suggesting investors are increasingly willing to pull money out.”

The ratings agency’s findings come at a time when, amid concerns of bond market illiquidity, regulatory representatives have questioned the merits of daily dealing.

Earlier this year, Alex Brazier, director of financial stability at the Bank of England, warned that many fund houses were “offering the same redemption facilities on high-yield corporate bonds as they always did on equities”.

He noted that policymakers, working via the cross-border Financial Stability Board, had been looking at existing tools used to counter illiquidity.

Mr Brazier said he also wanted to consider how a given fund’s liquidity could be reflected in initial redemption offerings. The Fitch report suggests concerns over liquidity mismatches may be well founded.

In an earlier piece of research Fitch found that, as of September 2015, 96 per cent of Ucits corporate credit funds provided daily liquidity with settlement typically occurring one day after the redemption request.

This is despite the fact that Ucits rules permit as few as two redemptions per month and settlement up to 10 days after the redemption request has been received.

Fitch noted that asset managers had focused on liquidity-management techniques, such as the use of derivatives and limits on the maximum percentage ownership of a specific security.

But the ratings agency warned that fund houses were less likely to abandon daily dealing because of the chance that the “first mover” could be punished with outflows.

“The potential commercial consequences through fund outflows of being a ‘first mover’ away from daily liquidity are likely to stymie fund provider appetite for adjusting fund liquidity terms,” Fitch noted.

“Additional regulatory scrutiny of liquidity risk management may instead be a driver for change.”

The agency also suggested it was “unclear whether asset managers’ greater focus on liquidity management techniques would be enough to match redemption demands in the event of severe market stress”.

It said declining liquidity in fixed income markets meant central banks, rather than investment banks and broker dealers, were now chief providers of a liquidity buffer.

KEY NUMBERS

94%: Proportion of Irish and Luxembourg Ucits funds offering daily liquidity, according to Fitch Ratings

96%: Proportion of high-yield funds offering daily liquidity