High yield analysts and managers have warned some of the largest funds in the sector are being hit by a liquidity crisis.
The sector’s popularity has rocketed since the financial crisis of 2008, as investors seek opportunities outside low-yielding investment grade and sovereign debt markets.
However, a corresponding drop in liquidity has meant managers with large funds or a single area bias, as well as mandates unable to use credit default swaps (CDS), are struggling to find opportunities, and will face difficulties when interest rates begin to rise.
The top four funds over one year in the IMA’s Sterling High Yield sector are all sub-£100m in size, with £1bn-plus vehicles from Neuberger Berman, PIMCO, SWIP, L&G, and Kames Capital all underperforming the sector average.
Claire McGuckin, co-manager of the £1.5bn Kames High Yield Bond fund with Phil Milburn, said the high yield market has taken on an ‘Alice in Wonderland’ quality, as an increasing number of funds crowd round a smaller number of trades.
Kames plans to soft-close the fund once it reaches £2bn in size.
“The market has grown as the ability of dealers to provide liquidity by taking things onto their balance sheets has reduced,” she said. “Anyone who thinks liquidity is not a problem for high yield is deluded.”
Trading has become harder as the fund has grown in size, she added, although a relatively large cash position allows her to move quickly on new ideas.
Fraser Lundie (pictured), manager of the £142m Hermes Global High Yield Bond fund, said the sector is at the start of a ‘huge change’ in strategy, as managers shift from US or Europe-focused mandates to a global approach, that incorporates the use of CDS.
“This is partly for liquidity reasons and also to allow managers to take a view on the cycle, because we are seeing more divergence in monetary policy between different geographies,” he said. “But a lot of money is still in narrow mandates”.
“Funds that cannot handle CDS are all fighting for the same 25 names – you cannot be a stockpicker when you are limited to that number.”
McGuckin and Lundie’s comments are echoed by two recent reports on the state of the high yield market.
Market-making activity by banks is down by as much as 80% since before the collapse of Lehman Brothers, according to research by Cerulli Associates.
“Before the credit crunch, managers said it had been possible to trade €10m-€20m of euro bonds fairly comfortably if required,” said senior research analyst David Walker.
“Since then, banks have dramatically scaled back their activities.
“Some managers are simply turning away mandates that stop them from using credit derivatives such as CDS, whose markets they see as more resilient to liquidity shocks than cash bond markets, and which allow them to take short positions easily to hedge against falling markets.”
Recent launches in the global high yield space, including offerings from Mirabaud and Royal London Asset Management, show the increasing popularity of funds which give the managers the freedom of a wider mandate.
Yoshie Phillips, senior research analyst at Russell Investments, said a recent report by the group found a number of the more established funds in the sector still have a home bias.
“A fair number of traditional US high yield bond managers continue to operate within the US bond market,” he said.
“Many of the money managers who do offer global high yield bond strategies tend to underweight the European and emerging market segments of the market relative to global index weights.”
Smaller credit funds began to reverse the trend in 2012, although large high yield funds continue to attract significant inflows.
Data from Fitch shows the smallest third of global credit funds attracted 40% of inflows during the past year, but the upper end of the market also continued to perform strongly.
A significant impediment to small funds with CDS exposure is that a large proportion of inflows come from first-time investors, who wrongly expect a larger vanilla fund to have a lower risk profile, Walker said.
“It is well documented how bad liquidity is, because a lot of the money coming in is first time money,” said Lundie, highlighting how large ETF flows have exacerbated the problem. “It has only been in the last few months that other funds have really begun to see the attraction of CDS.”
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