Big bond funds at risk in liquidity crunch

The financial crisis of 2008 caused a number of large banks to withdraw from bond markets, which means that the secondary bond market - where bonds are traded following their initial sale - has now shrunk to around of a quarter of its 2007 peak.

According to Aberdeen Asset Managers, this has significantly reduced institutional investors' ability to buy and sell bonds; over the past five years the trading universe for investment grade bonds has shrunk by over a third, with only 60 per cent of top tier corporate bonds now able to trade.

Subsequently, Aberdeen claims that the UK regulator, the Financial Conduct Authority (FCA), is becoming increasingly concerned about the situation and asking managers to warn clients of potential losses that could be incurred.

'We are concerned about liquidity. We have recently had meetings with the FCA as it is very keen for us to stress to our clients that liquidity in bond markets is currently poor, which could lead to losses.

'In particular, this could be a problem for very large funds in single asset classes as they could run into trouble in a liquidity crunch. So managers like M&G, Legal and General and ourselves need to be cognisant of the risks,' says Roger Webb, manager of Money Observer Rated Fund Aberdeen Strategic Bond.

Some of the UK's largest corporate bond funds include M&G Optimal Income - the largest at over £23 billion of assets under management - Invesco Perpetual Corporate Bond (£5.5 billion), Fidelity Moneybuilder Income (£3.4 billion) and Aberdeen Global High Yield Bond (£1.4 billion).

Webb claims that reduced liquidity is being somewhat eased through the use of derivatives in bond markets, which is essentially helping bonds to trade 'at the margins', as well as the loosening of regulations that are allowing UK bond managers to venture further into US and European markets, where there is better liquidity than in sterling markets.

Additionally, he claims that institutional investors are increasingly buying and holding large bond issues from big corporations, meaning that there is less need for a liquid market to trade, which arguably creates a more stable, less volatile environment for fixed income.

However, Webb warns that the future will not be easy for bond managers: 'The ability to buy and sell bonds has diminished in recent years, but that just means that we have to work harder to find the right prices.'

Nonetheless, he adds, some 'risky areas' are in fact now more liquid (and hence easier to trade in) due to brokers charging lower fees, and so Aberdeen is increasingly finding opportunities in areas including high yield, corporate hybrids and 'fallen angel' corporates such as Tesco.

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