November 7, 2016

Monday Morning Memo: Bond Funds Not Ramping Up Credit Risk

by Jake Moeller.

“Lower for longer” is the new mantra. Certainly in the U.K. and Europe and perhaps a little less so in the U.S., the anchoring of low end rates continues to drive yield-thirsty investors to distraction.

Whispers about a bond bubble have been around for several years now, but with asset buying by central banks becoming an established policy measure, utterances are becoming louder and are coming not just from investors. There has been several high-profile investment executives warning of bond overheating.

Large inflows have forced the hands of many bond fund managers to seek ways to fully invest them. The average bond size in the IA Strategic Bond sector sector for example, has increased from £410 million in September 2011 to £610 million in September 2016. Increasingly, bigger funds contain more securities or larger positions in individual lines, with managers sometimes being forced to move up the credit spectrum to maintain a decent yield in a world of tight compression.

Have these inflows caused a material increase in credit risk for bond funds? It is worth examining two popular bond sectors to see in which credit buckets U.K. bond fund managers are concentrated.

Sterling High-Yield

Looking at the Investment Association (IA) Sterling High-Yield Bond sector: As of September 30, 2016, the highest average allocation was in BB-rated credit (39.0%) followed by B-rated (33.9%). Twelve months ago, these allocations were 38.8% and 37.4%, respectively. Five years ago (as of September 30, 2011) the average sector exposure to BB-rated securities was 34.4%, with 36.0% to B-rated securities. For 2016 average exposure to A- or better-rated securities was 10.9%, but for 2015 this figure was 8.8% and for 2011, 14.8%.

Exhibit 1. IA Sterling High Yield Bond Sector – Debtor Profiles

The balance between investment- and non investment-grade securities overall moved up for 2016: there was a total of 18.6% in investment-grade, up from 13.6% for 2015 and down from 21.7% for 2011. The most significant change over the last 12 months was the drop in aggregate exposure to riskier unrated securities: 4.8% for 2016, down from 10.3% for 2015, appearing to have funded the commensurate increase into investment-grade securities.

Sterling Strategic Bond

In the “go anywhere” IA Sterling Strategic Bond sector the highest aggregate concentration as of September 30, 2016, was in BBB-rated securities (25.7%), followed by BB-rated (15.2%). For 2015 this pattern was similar, with 23.7% and 14.6%, respectively. For 2011 portfolios in this sector contained an average of 20.8% in BBB-rated securities, with the highest allocation being to AAA-ratings (23.4%).

Exhibit 2. IA Sterling Strategic Bond Sector – Debtor Profiles

The overall aggregate exposure to investment-grade credit for 2016 was 58.9%. For 2015 this figure was 57.5% and for 2011, 66.7%. Aggregate exposure to unrated securities in this sector was 9.2% for 2016, down from 10.4% for 2015 and up from 8.2% for 2011.

Conclusion

In aggregate, over the last 12 months and compared to five years ago, it appears credit bond fund managers have not materially decreased the quality of their portfolio holdings. Fund managers appear to be backing their ability to “cherry pick” in safer credits and are not chasing riskier credit for the sake of it–even though the credit cycle has been extended. This should provide investors some comfort in the case of a rapid rotation out of corporate bonds.

In a recent interview with Thomson Reuters Lipper, Stephen Snowden, Head of Credit at Kames Capital, dismissed concerns about a potential credit bond bubble. His belief is that liquidity risk in corporate credits is “not currently a systemic one” but rather is about individual managers managing their liquidity at a portfolio level.

Perhaps then, investors should be keeping an eye on the size of their bond funds and considering capacity constraints rather than being overly concerned about credit composition.


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