London: The European high-yield bond fund sector appears to be operating with significant liquidity risk, Fitch Ratings says. Most funds offer daily liquidity to investors despite limited allocations to highly liquid investments. The recent gating of the Woodford Equity Income fund, which had material holdings of unlisted equities, highlights the dangers of offering high liquidity while investing in less-liquid securities, including forced asset sales, material net asset value reductions, gating and potential knock-on effects to the broader financial system.
We analysed Europe’s five largest UCITS high-yield bond funds, with combined assets under management of EUR43 billion at end-March 2019. The funds all offer daily dealing but their holdings of highly liquid securities are limited. We found substantial variation across funds, but on average only 4% of their investments were in cash and only 14% in instruments rated ‘A’ or above, with ‘AAA’ the lowest allocation. Duration averaged three to four years for these funds, depending on the extent to which they included floating-rate securities in their portfolios.
High-yield bond funds are just as likely as government bond funds to offer daily liquidity. To counterbalance the lower liquidity of high-yield securities, they need a diverse investment portfolio to reduce the likelihood of having to divest holdings in distressed names or sectors to pay redemptions. Crucially, they also need to hold appropriate levels of cash or highly liquid investments to help meet spikes in investor withdrawals.
Fund managers face competing demands of liquidity and investment performance. The more cash and highly liquid assets a fund holds for liquidity, the lower the likely yield. This struggle, combined with limited regulatory restrictions, means that liquidity at some funds may not be sufficient to cope with a severe market stress. There are signs that regulators are increasing their focus on liquidity. Tighter regulation leading to a reduced liquidity mismatch would be credit positive for funds and the financial system more broadly.
Funds do not have to offer investors daily liquidity. UCITS regulation provides for funds offering investors various levels of liquidity, including extended settlement periods (up to 10 days) and less frequent dealing (as little as twice a month). However, the asset management sector has opted en masse for daily liquidity, presumably on the basis of investor demand. It may take tighter regulation or a severe market stress to change this approach.
A potential market stress emanating from open-ended bond funds could take multiple paths and affect several sectors. Investment managers could suffer a reduction in assets under management and associated fees, reputational damage or litigation. Banks and non-bank financial institutions could be affected by falling collateral values or by loss of short-term funding from open-ended funds.