Should Corporate Bond investors be worried?

In June 2019, Neil Woodford, one of Britain’s most high-profile fund managers, suspended trading on his UK Equity Income fund after an increase in redemption requests. Following the suspension, the Bank of England noted in their subsequent Financial Stability Report that the episode ‘was not systematic in nature’ but that future similar occurrences could be. The report recommended that funds' assets and investment strategies should be consistent with their redemption terms. The Financial Conduct Authority have also had to reassess its impending rules for governing open-ended funds, which were originally proposed following the fallout from the Brexit vote when several property funds were gated. These recent incidents have prompted investors to question where the next liquidity squeeze may take place, with many viewing the corporate bond market as an area of concern.

Unconventional monetary policy programmes

Following the financial crisis in 2008, central banks around the globe embarked on unconventional monetary policy programmes to stimulate their respective economies. Quantitative Easing involved the large-scale purchase of government bonds by central banks, while interest rates were lowered to promote lending and to stimulate business activity. In the US, the federal funds rate was slashed to 0.25% in December 2008 and remained unchanged until December 2015, when the Federal Reserve slowly began on its path of normalising its benchmark rate. As a result of this ultra-low interest rate environment, global debt in the form of corporate bonds issued by non-financial companies reached almost USD 13 trillion at the end of 2018, twice the amount in real terms that was outstanding in 2008*. As the path of global monetary policy becomes increasingly uncertain, investors should be aware of the changing dynamics of the corporate bond market since the crisis, and the risks and vulnerabilities that now exist in this asset class.

New financial regulations

In contrast to trading shares, which can be matched through an electronic order book, corporate bonds are traded over-the-counter, by calling a dealer. Prior to the financial crisis, broker dealers and hedge funds were the most important providers of market liquidity in corporate bond markets. Following the financial crisis, a range of new financial regulations were implemented including Dodd-Frank, the Volcker Rule and Basel III. While each of these are comprehensive pieces of legislation in their own right, they essentially placed constraints on market participants, reducing their capacity to expand their balance sheets. Since these regulations came into effect, there has been a shift in the business model of the traditional broker dealer as a decline in risk tolerance has resulted in them significantly reducing their inventories and concentrating their holdings in higher grade bonds. Many have moved away from supporting liquidity and trading in secondary markets in favour of underwriting new issues in the primary market. The number of hedge funds operating in corporate bond markets has also decreased sharply as their ability to obtain bank financing for their liquidity provisions has reduced. There is a consensus that it has become more difficult for market participants to execute trades and that smaller block sizes and longer order times have become the norm.

Mutual fund & retail investor tourists

As the market liquidity ‘pipeline’ for transactions has narrowed relative to the size of the market, there has been a substantial increase in mutual fund and retail investor ‘tourists’ who enter the market in search of yield. These investors tend to be less comfortable with volatility while the rise of ETFs and passive strategies is another factor which could contribute to a heavy level of selling during the next bout of market stress. A prolonged decline in overall bond quality has been well documented, increasing the likelihood of fallen angels. This exposes some market participants to forced selling if they are obligated to sell bonds in their portfolios which have been downgraded by rating agencies.

What does this mean for UK corporate bond investors and should they be worried?

The evolution of liquidity

In June 2019, the International Organisation of Securities Commissions (‘IOSCO’) issued a report entitled ‘Liquidity in Corporate Bond Markets Under Stressed Conditions’ to assess how corporate bond markets might behave under stressed conditions, given the structural changes that have taken place over the past decade. In preparing the report, the authors conduct interviews and discussions with a wide range of market participants. They review a collection of academic journals and summarise the main results of previous work on liquidity in corporate markets under both stressed and normal conditions. They also present ten case studies in the report of how liquidity has evolved during past stressed conditions in secondary markets. Some of the more recent case studies include the Argentinian financial stress in 2018, the post US election sell-off in late 2016 and the ‘Brexit’ vote in June 2016. Whilst the report confirms that the structural evolution of the market has undoubtedly become more challenging in recent years, they conclude that institutional investors, such as mutual funds, pension funds, insurers and sovereign wealth funds are likely to be able to provide enough structural demand-side support during stressed conditions. They find that corporate bond markets have shown signs of significant resilience from the ten case studies and allude to the sophistication of liquidity risk management programmes which have also evolved to recognise the increased risks and vulnerabilities in the market.

Portfolio positioning

To conclude, the most recent academic report on corporate bond liquidity may bring a level of comfort to investors who are worried about the asset class. It is important to highlight however that the question of how liquidity behaves under stressed conditions is speculative as future episodes may develop in ways different to those of the past. The recent suspension of the Woodford UK Equity Income fund and the gating of a number of UK property funds has increased the scrutiny on portfolio managers to position their portfolios to handle an increase in redemption requests, without having to conduct ‘fire sales’ of their corporate bond assets. At RSMR, we remain cognisant of the risks of investing in this asset class. We seek to identify established funds with strong risk management frameworks in place, whereby the manager can demonstrate an excellent track record and specialist knowledge within the asset class.

Patrick Morris, Investment Research Manager, RSMR