Home Stock & Shares Will Bond Funds Be The Next Liquidity Crisis?

Will Bond Funds Be The Next Liquidity Crisis?

by Jonathan Adams
Liquidity

After the Brexit referendum in 2016, and again in December of last year, several major UK property funds faced severe enough liquidity crises that they were forced to lock investors in. Last year, the high profile Woodford Equity Income fund had to do the same, before its authorised corporate director Link Fund Solutions chose to wind the fund up due to a perceived lack of progress in liquidating assets to pay back investors who wished to withdraw funds were the suspension to be lifted. Some experts now believe bond funds could be the next asset class at risk of a liquidity crisis.

Liquidity crises hit open-ended funds when investors move to redeem their holdings in numbers, or to values, which mean cash reserves held by the funds are insufficient to cover requested payouts. Of course, a fund can also sell off assets to raise more cash but this can take time if a reasonable price is to be realised. And if enough assets need to be sold off by one or more funds in the same space, this can tank prices.

The result, as seen during the property and Woodford fund liquidity crunches, is that funds can then be forced into suspending withdrawals. Suspending a fund is usually justified as necessary to protect investors who wish to remain invested. It prevents its value from crashing due to a heavy loss of capital and assets being sold off at below market value.

By the time a suspension is lifted, the hope is the fund will have managed to sell off enough of its assets in an orderly fashion to pay out on redemptions. Some investors who had been ready to leave at the point the fund was suspended may also have cooled off and reconsidered, reducing overall withdrawal requests.

A growing number of analysts are now of the belief that bond funds could be the next asset class to hit liquidity problems. It’s certainly not a scenario that is locked in but the increase of capital flows, £10.5 billion from UK investors last year, has led to concerns a bubble may have formed.

Investors have moved into bonds either as a refuge from the fear the record long bull run equity markets have been on will have to eventually come to an end in the not-so-distant future, or as an alternative to record low yields on cash savings. The increase in demand for bonds has pushed prices up and yields down.

Bond yields roughly follow interest rates, so when they rise, so do the yields offered on freshly issued government or corporate bonds. Bond prices move in the opposite direction – falling when yields grow. With interest rates, and bond yields, now at record lows for years (in 2010 high quality bonds offered around 6%, which has since dropped to around 2% or even less than 1% for government bonds), many analysts are convinced both will have to rise in the longer term. That would see bond prices fall.

Most private investors also invest in bonds through bond funds, which means charges, on average around 0.5% per annum, eat further into returns. With inflation at around 1.3%, most low risk bonds today represent negative real returns.

David Jane of fund manager Miton comments:

“This forces investors who are seeking income with not too much risk either to pay for low risk by accepting bonds with ultra-low yields, or to get higher income by moving to higher-risk bonds.

“With central banks buying up large swathes of the less risky bonds, investors face an unenviable choice: either they crowd onto a shrinking island of high-quality but low-paying bonds, or they swim with the sharks in the pool of riskier high-yield bonds.”

If interest rates and bond yields rise in future years, this will benefit investors in newly issued bonds but not existing bond-holders. The price of their bond holdings would be expected to fall, leading to capital losses adding to already pitiful coupons.

UK interest rates could even be cut further in the short term, something markets currently see as around 50% likely. But many experts are convinced that they can remain as low as in recent years for long.

When they do begin to rise, many bond fund investors may well decide they wish to cash in their holdings. If that turns into a rush for the exit, these funds may encounter the same kind of liquidity issues as property funds and the Woodford fund recently experienced.

Dipan Roy of NFU Mutual comments:

 “I suspect that the size of the exit door is not large enough to handle a rush by a large number of investors.”

Important
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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