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Demand for junk bonds grows, and so do liquidity worries

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Demand for junk bonds grows, and so do liquidity worries
A trader works at Frankfurt's stock exchange in Frankfurt, Germany February 6, 2018. REUTERS/Ralph Orlowski   -   Copyright  RALPH ORLOWSKI(Reuters)
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By Abhinav Ramnarayan and Simon Jessop

LONDON (Reuters) – Mutual funds are piling into riskier company debt as the European Central Bank considers further stimulus, raising concern among bankers and investors that some may be caught in a liquidity squeeze when the economic cycle turns.

The ECB is expected to resume buying corporate bonds this year to revive a faltering economy, crimping the returns from investment-grade bonds and pushing investors into so-called junk debt.

Over 1.1 billion euros flowed into euro-denominated high-yield debt funds in June, data from Refinitiv showed, taking total assets to a 53.7 billion, the highest for nearly two years and a sliver away from an all-time high.

From the end of March to the end of June, 12 of the 20 fund categories tracked by Morningstar showed increased allocations to junk-rated corporate debt, with ratings of BB, B and below.

But high-yield debt is less easy to sell quickly, so a sharp change in sentiment could see clients demanding their money back at the same time, potentially forcing some funds that promise daily exits to their clients to suspend trading.

“More and more people are trying to get high-yielding assets and so they’re (going to parts of the market that are) more and more exotic,” Peter Harrison, chief executive at British asset manager Schroders <SDR.L>, said. “That, for me, does create mis-matches, people not really understanding the inherent risks.”

A selloff in European junk bonds last week highlighted the dangers. Triggered by escalating trade tensions between China and the United States, European high-yield bonds suffered their worst session for eight months, with Markit’s iBoxx euro high-yield index up 10 basis points on Monday.

“The selloff was a reminder that there still is that dislocation between high-quality names and low-quality (companies),” said George Curtis, a portfolio manager at TwentyFour Asset Management. “Some of the companies issuing bonds now are the skeletons of tomorrow.”

The European investment-grade bond market is large and liquid, with a total outstanding size of about 2.7 trillion euros, Refinitiv data showed. The European high-yield bond market is about 432 billion euros.

In the United States, the high-yield market is much larger, at around $1.9 trillion.

GRAPHIC: Yield-starved investors opt for junk bonds –

Liquidity concerns have been at the centre of three high-profile fund blow-ups in recent months – the ongoing suspension of stockpicker Neil Woodford’s equity income fund; the temporary gating of Natixis affiliate H2O’s funds; and the ultimate closure of a number of funds at Swiss asset manager GAM.

While the triggers for each were different, investors’ ability to get their money back was hampered by the liquidity of the funds’ holdings.

At Woodford, nearly 300,000 retail investors were exposed to the suspended fund on British investment platform Hargreaves Lansdown alone, highlighting the potential ramifications of similar incidents in the future.

Bank of England governor Mark Carney has been particularly vocal, saying funds that are buying illiquid assets but promising daily exits are “built on a lie”.

While none of the issues faced by Woodford, H2O and GAM were related to the high-yield bond market — which are publicly traded and by definition more liquid than private assets — investors warned liquidity risks do exist.

“Liquidity can dry up fast when market conditions turn sour,” said Leslie Sita, a portfolio manager at Lombard Odier’s Fundamental Fixed Income Team, who favours bonds on the cusp of investment grade rather than those deep in junk territory.

Amplifying the risk of these holdings is the absence of investment banks as buyers in a stressed environment.

Before the financial crisis, investment banks would almost always be prepared to buy, but the impact of tighter capital rules introduced since then mean they would be unable to fill the gap in any future market panic.

“The buyer base may understand the market and the risk, but compared to a decade ago, banks are not set up structurally to be warehousers of risk and so liquidity risks are higher,” said one banker who manages high-yield bond sales in Europe, preferring to remain unnamed.

“It’s one thing when you’re looking to sell 2-3 million euros (of debt). But when you’re looking to ship 50 million euros – that is more of a challenge.”

(Reporting by Abhinav Ramnarayan, editing by Larry King)

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