UK fund house BlueBay has warned of structural illiquidity in the credit market caused by increasing regulation, fearing investors may face problems if they head to the exits as quantitative easing is wound down.
The fixed income credit specialist, which has $53.9 billion in assets under management globally, is no believer in the great rotation from fixed income into equities. Data shows net investment into both asset classes, mostly out of money-market funds rather than out fixed income to equities (see chart).
While BlueBay acknowledges that an eventual rise in interest rates is inevitable, it does not see scope for uncontrolled rises on account of structural impediments in an indebted world. It also argues that liability-driven investors will continue to invest in fixed income as they have liabilities they need to hedge.
But Alex Khein, partner and chief operating officer at BlueBay Asset Management in London, points to the withdrawal of investment bank liquidity as a key risk that has built up in the financial system, one of the unintended consequences of the post financial-crisis regulatory reform.
He notes that stricter capital requirements on banks have driven them to reduce their trading desks and risk budgets, causing investment banks to switch from being warehouses of risk to largely agency-brokers.
Khein observes that dealer inventories have gone down over the past five years at the same time as the preponderance of daily, liquid fixed income credit funds has gone through the roof.
Implied is that the world of fixed income is getting less liquid. “Structural illiquidity in the market has, in recent years, been masked by strong inflows into the asset class," he notes
“That is a structural headwind caused by both market dynamics and regulation. It’s an example of one of those things with unintended consequences that may not create a problem, but there is a risk that it does and it gets tested.”
Provisional data from Morningstar shows that the major outflow from all fixed income funds came in June, post initial tapering comments from US Federal Reserve chairman Ben Bernanke in May. An estimated $85.2 billion flooded from bond funds globally during the month. But estimated net flows recovered in July to a positive $5.1 billion.
Only yesterday, the Financial Times reported that a number of global investment banks were shrinking their business of trading government bonds and other rate products on the back of a 36% fall in revenues in the first half of the year, citing Coalition research.
It comes at a time when global corporate bond issuance has fallen to its lowest level in five years. Just $61 billion in investment grade corporate debt was raised in August, which is shaping up to be the worst month since 2008, according to data provider Dealogic.
Khein remains convinced the great rotation is a misunderstood concept, more of a reference for the man on the street. “It would be difficult for a pension fund or set of trustees to say the structural issues holding equities back are gone. Those impediments mean we are likely to continue to be in a constrained growth world and in that scenario fixed income will do well.”
He expects institutional investors to focus on alternative forms of fixed income credit, with concern over interest-rate rises driving them to non-benchmark absolute-return funds where managers are given the freedom to invest across the spectrum of bond instruments.
He sees the major investment categories as being global themed products within three channels: traditional benchmarked funds, total return products with a long bias and absolute return funds.
BlueBay is based in London and has offices in Luxembourg, Hong Kong, Japan and the US. Its core investment focus is in emerging markets and global investment grade credit. It also offers leveraged finance and convertible bonds. Some 80% of its assets are sourced from Europe, with up to 15% from Asia including Japan and just 5% from the US.