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.
