Major institutions such as the IMF and the US Federal Reserve have warned about the falling levels of liquidity in corporate bond markets and the devastation that could create if yields were to spike from their historically low levels.
Many industry experts believe this present a far bigger problem for the giant funds in the sector, with some suggesting they won’t be able to meet the redemptions that would occur in such a liquidity driven sell-off.
However, should investors really be concerned?
People have deemed corporate bond funds to be very unattractive for some time now, with most advising that investors who need fixed income exposure to turn to strategic bond managers given they have a greater degree of flexibility.
Nevertheless, it is worth pointing out just how well corporate bond funds have performed over the longer term and why they have been the mainstay of a retirement of income portfolio as a result.
Performance of sector versus index since January 2000
Source: FE Analytics
As the graph above highlights, FE Analytics shows the average member of the IA Sterling Corporate Bond sector has significantly outperformed the UK equity market since the turn of the century with gains of 105.79 per cent.
However, it has also done so with far lower annualised volatility and maximum drawdown.
The graph shows that corporate bond funds fared well during the credit boom years prior to the financial crisis, but have rallied even harder since 2008 thanks to very easy monetary policies from the world’s central banks with ultra-low low interest rates and quantitative easing forcing yields down.
Although spreads have widened somewhat during the recent market volatility, with yields still historically low and other factors at work, what does the future hold for corporate bond funds? I took this as the theme for a piece of research that was presented at today’s FE Trustnet Select event on fixed income.
Regular FE Trustnet readers will no doubt have heard about the doomsday scenario facing the corporate bond market.
Since the global financial crisis, regulatory pressures have forced investment banks to step away from their traditional ‘market maker’ roles and reduce inventory. But, over that period, the corporate bond market has exploded in size.
Though some still disagree with this, the consensual view is that this dynamic has had an adverse effect on market liquidity.
The likes of RBS’ ‘Liquid-o-Meter’ from 2014 show, for example, that liquidity in bonds – which the group define as a combination of market depth, trading volumes and transaction costs – has fallen by 70 per cent since the crisis and, more worryingly, is still falling.
Liquidity in corporate bond markets
Source: RBS Credit Strategy, SIRMA, MarketAxes, Federal Reserve Bank of New York
The graphs above are both from that report, showing trading volumes steadily declining over the longer term and dealers estimated holdings (or general broker inventory) also falling while the size of the credit market has greatly increased.
The big concern, therefore, is that if the very easy monetary policies of the past seven or so years start to reverse for any reason (therefore causing bond yields to rise sharply), will managers in corporate bond funds have the underlying liquidity to meet the expected redemptions?
Some major institutions such as IMF and US Federal Reserve have sounded warnings about the potential liquidity threat facing the corporate bond market, while Wall Street banks like Goldman Sachs have suggested this potential event could be the cause of the next financial crisis.
When we have written about this issue in the past, though, the large majority of people we have spoken to believe this threat poses a bigger problem for the biggest multi-billion corporate bond funds and strategies.
“The bigger the fund, the bigger the problem. If you run £25bn, 1 per cent of that would be £250m. The market cannot take that; in reality, it can hardly take a fiver,” Kames’ Stephen Snowden told FE Trustnet in 2013.
These concerns are relatively simple to explain. If yields were to spike and investors starting selling their units en masse, managers running large strategies will struggle to offload their assets as efficiently as those running smaller pools of money.
The jury is still very much out on whether larger funds are at more risk in such an event, as we found during our most recent survey.
As the chart shows, while more FE Trustnet readers believe larger funds are at most risk during a liquidity driven sell-off than those that don’t, the majority of you aren’t sure.
Clearly, there is a lot of uncertainty in relation to the future of corporate bond funds so we decided to look back and see whether size has really impacted performance in the past.
To do this, we built various portfolios of the largest and smallest corporate bond funds from points in history. Firstly, we looked at the a portfolio of the 15 largest IA Sterling Corporate Bond funds this time 10 years ago – which together made up £13.6bn worth of assets – versus the 15 smallest funds 10 years ago – which made up £615m.
Performance of largest and smallest funds over 10yrs
Source: FE Analytics
As the graph shows, there has been very little difference in performance between large and small corporate bond funds – taken on average – with the smallest outperforming by 35 basis points over the past decade.
Of course, the major concern is how giant bond funds will perform when yields spike and liquidity dries up – so we looked at the performance of the largest and smallest funds during periods in the past when that has happened.
One of the best examples was in 2008 during the financial crisis – at time when the 15 largest funds totalled £13.6bn and the smallest 15 accounted for £859m.
Performance of largest and smallest funds in 2008
Source: FE Analytics
Taken on face value, it seems investors were rewarded for backing smaller funds during that year with 15 largest funds losing – on average – 4 percentage points more and posting bigger drawdowns. But was this down to fund size?
When investors are presented with data like this, it is important to look more closely under the bonnet and by doing so some interesting themes emerge.
For example, Standard Life TM Corporate Bond was the second largest member of the peer group at the time at £2.8bn – and yet it only lost 2.4 per cent placing it in the top decile in 2008.
Also, while CF Canlife UK Corporate Bond – which was one of the smallest at the time with assets of £60m – made 3 per cent during the crash, Rathbone Ethical Bond – which was £5m smaller at £55m – fell 20 per cent.
Therefore, it’s hard to make the argument that the difference in performance between small and large funds in 2008 was purely due to size. In fact, the biggest driver of returns was probably positioning – with funds with a more defensive and higher quality tilt outperforming those with exposure to more cyclical areas.
It’s a similar story in more recent times when liquidity has dried up in the market, such as 2013 when the US Federal Reserve said it wanted to ‘taper’ its QE programme – which had propped up nearly all areas of the market – and caused a pan-asset class sell-off.
While the 15 largest funds (which totalled £55.2bn) were seemingly hit harder than the smallest 15 (which together made up £712m) during the actual sell-off in June of that year, they went on to narrowly outperform by the end of the 2013.
So it seems size has had little effect on performance in the past and there are many, such as FE’s head of research Rob Gleeson, who say it will have no effect in the future.
Gleeson points out that there are a number of issues that need to be taken into when debating the issue.
“The corporate bond market is not like a stock exchange. It’s a group of people who might want to buy and sell bonds. There is some listed stuff, but there is a lot more over the counter transactions in corporate bonds than elsewhere,” Gleeson said.
“What scale gives you is access. The top tier brokers, the top tier investment banks, want to deal with the likes of M&G and Invesco, but aren’t so bothered about some of the smaller boutique firms. When it comes to liquidating assets, firms that have the scale, the dealing capabilities and the access have a bit of an advantage.”
It is also worth noting that many of the sector’s giants use derivatives extensively, which ease potential liquidity constraints given they offer synthetic, rather than physical, exposure.
Gleeson (pictured) also points out that if credit yields were to spike dramatically, given the world is starved of income, natural buyers would enter the market and provide a floor to bond prices and limit potential losses. 
However, if a ‘black swan’ crash were to happen – say if central banks had to raise rates drastically to cope with raging inflation – he firmly believes it wouldn’t matter whether investors were in giant or tiny bond funds: both would be hit with severe losses.
So what conclusions – if any – can be made?
Well, from my point of view I think it is difficult to make a strong argument that fund size has affected performance in the past – either over the long run or during previous periods of market stress. However, what I would say is that it doesn’t mean it doesn’t have the potential to in the future.
After all, investors are now in completely unchartered territory.
Bond yields have continued to fall, many argue market liquidity is still poor and declining, and recent data shows inflationary pressures are returning which is likely to put pressure on valuations in the asset class while – at the same time – bond funds have never been as big as they are today.
If the much prophesised collapse of the bond market does occur, will giant bond funds be hit hardest by the lack of liquidity? We don’t know.
But unfortunately, and rather ominously, it is likely to be a case of ‘we’ll have to wait and see’.