Volatility at the beginning of the year provided a healthy reminder that financial markets have become less stable.
In February, Alex Brazier, the Bank of England’s executive director for financial stability, strategy and risk, outlined the risks lying potentially dormant within the corporate bond market, in a speech at Imperial College. Mr Brazier focused on two main causes for concern 10 years on from the financial crisis.
Bank leverage
The first is that corporate bond markets are less liquid than before the crisis. Reflecting restrictions on bank leverage, deal-makers have become less willing to warehouse corporate bonds. The second risk Mr Brazier identified stems from another secular trend: the rise of open-ended mutual bond funds.
Since 2017, open-ended bond funds in the UK and the eurozone have grown by 70 per cent and in the US by 150 per cent. The concern here is that these funds may inadvertently trigger a fire sale of assets if investors request redemptions at a faster rate than the fund is able to sell the assets in the market.
Since the introduction of the EU Prospectus Directive in 2004, it has been increasingly difficult forretail investors to buy individual bonds given the perceived complicated nature of this asset class. In truth, they are simpler to understand than equities. Combined with the long bull market in bonds, this has driven vast retail flows into open-ended bond funds, which provided the only viable alternative route into this asset class.
The weakness of the Prospectus Directive approach is that it fails to recognise that bonds held in an open-ended structure lose their defining characteristics as bonds. A private investor putting a portfolio together of individual bonds is able to make a judgment on when they might need the money they have loaned. They will therefore have an eye to the redemption date, alongside the coupon and the security of the credit, and plan their portfolio of bonds accordingly.
Bear market
In the event of a bear market in bonds, providing they are still content with the quality of the credits that they hold, private investors will have no need to panic sell. Instead, they can hold the bonds until they mature, as most private investors used to do. However, with a bond fund that essential characteristic is lost.
If the fall in bond market prices continues and possibly accelerates, retail investors will simply see a worsening decline in the unit price of their funds. There will be no redemption dates to hold onto and what is more investors have very little idea of what they really own. If panic selling were to ensue, the fund manager’s liquidity (in cash or shorter-dated bonds) would be quickly paid out to the early sellers, leaving other investors holding the illiquid and longer-dated issues.
Key Points
• Corporate bond markets are less liquid than before the financial crisis.
• If the fall in bond prices continues, retail investors will see a decline in the price of their funds.
• An alternative may be for retail investors to buy individual units.
In these circumstances, and to protect the remaining unit holders, funds would need to consider gating – suspending transactions until liquidity returns. Apart from a brief period following the Brexit referendum, the last time long-term gating occurred among property funds was in the late 1980s. At that time, some unit trusts were unable to sell their underlying properties to meet redemptions and had to gate the funds.
Orderly markets did not really return for six years. During this time, it was difficult to price assets correctly. In the absenceof a price, private investors had no idea of the value of their investment and could not sell.
Lack of demand
This echoes the point made by Mr Brazier about the lack of liquidity in the bond market. For almost 25 years this market has gone in only one direction and has consequently sucked in enormous sums from private investors, much of it in the belief that bonds were safer than equities. Were private investors to start selling, it is unclear whether there is sufficient institutional capacity out there to buy all that paper.
To compound the issue, perhaps the only investor group with the cash and inclination to buy individual issues selectively might well be retail investors escaping from the bond funds, but wishing to hold bonds. Unfortunately, however, they are prevented, by the Prospectus Directive, from doing so.
This is doubly unfortunate, as the tax system actively encourages investors to buy these corporate bonds as prices of issues decline below par, since most fall outside of capital gains tax. This thereby enhances the net yield to redemption, which obviously makes it more attractive for private investors to buy. It is to be hoped that in time they may be able to do so once again.
Meanwhile, if we can increase the public’s awareness of the potential liquidity issues inherent in open-ended bond funds, then it may be enough to discourage those whose time horizons are not well suited to less liquid products to seek more appropriate investments.
Advice needed
Raising these issues publicly is more important than ever as retail investors suffer a chronic absence of truly independent financial advice. There are insufficient financial advisers in the UK and this advice gap has made it much harder for retail investors to choose financial products and assets that match their investmentgoals, retirement preferences and lifestyles. This is the challenge the financial industry must address, sooner rather than later.
Paul Killik is founder and senior executive officer of Killik & Co
