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This is what could disrupt the bond market: Fitch

Frank Van Den Bergh | E+ | Getty Images

There is a potentially huge risk lying in the bond market, according to ratings agency Fitch, and it centers on the mismatch caused by funds offering daily liquidity but holding securities which may be less liquid.

As the multi-week sell-off in U.S., U.K. and German sovereign bond markets gathers momentum, a Fitch report published Monday highlights the risks to the value of assets held in funds should there be a stampede for the door by investors.

According to its authors, Manuel Arrive and Alastair Sewell, both Senior Director at Fitch: "Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility."

The Fitch analysts call into question the suitability of offering daily liquidity for as many as 90 percent of UCITS (mutual funds based in the European Union) bond funds.

The report also raises a red flag over portfolio managers, who are attempting to diminish the threat of liquidity issues, having to adapt investing strategies in ways which could affect the return potential of their funds. Among the methods cited by Fitch, it is suggested some managers may be being forced to take smaller positions and over-diversify holdings as well as retain a higher balance of cash and liquid securities.

However, a report by asset manager BlackRock (updated and reissued this month) challenges some of the fears being stirred up around changing liquidity conditions within the fixed income market. While acknowledging widely flagged issues such as reduced turnover of fixed income securities, the gigantic amount of liquid securities that have been snapped up by central banks in recent years and a decline in broker-dealers' capacity and appetite for warehousing debt largely due to regulatory changes, BlackRock says not enough attention is paid to the impactful ways in which the industry is changing to accommodate the new parameters.

It also highlights the positive and offsetting effect that it says index-tracking exchange-traded funds (ETFs) are having on the market.

According to BlackRock, "Bond turnover data omits critical elements of today's bond market structure, including bond ETF trading volumes,which have increased significantly, while individual bond turnover has declined."

ETFs can create a second layer of bond market liquidity as ETF shares are traded among buyers and sellers without the underlying fixed income securities within the ETF structure ever hitting the market. However, the index-tracking nature of ETFs could exacerbate volatility, punishing liquidity and the value of mutual fund holdings, should a bond market sell-off accelerate quickly.

The risk of a daily liquidity fund holding illiquid assets was highlighted when several U.K. asset managers felt compelled to put a halt on redemptions of their commercial property funds in the wake of the EU referendum as investors tried to flee the asset class en masse. Even today, not all of these funds have lifted their trading suspensions.

A recent study by Preqin has highlighted the increasing preference of institutional investors to pivot towards opportunities in less liquid assets, with survey participants saying they planned to increase their allocations to private debt and private equity by 67 percent and 56 percent respectively over the long-term.

It remains to be seen whether this growing preference for asset classes with longer investing horizons is accompanied by a broader investor acceptance of capital being locked-up for longer and a rethink on the design of certain daily liquidity products offered by asset managers.

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