Fitch: Search for Yield Leads to More Risks in Credit Funds

Fund managers may be tempted to look for opportunities in lower-rated, less liquid, off-benchmark or longer-maturity bonds. This can lead to excessive risk-taking - there is a growing consensus among asset managers that the risks are beginning to outweigh the rewards, due to an overall increase in liquidity, re-pricing and idiosyncratic risk.

The inability to maintain discipline in credit selection and liquidity risk management, or the inability to de-risk the portfolio in a timely manner may put pressure on some fixed income Fund Quality Ratings. Furthermore, a potential change in market regime or market re-pricing (exacerbated by poor liquidity) may lead to more differentiation between funds’ performance, which in turn could lead to select rating actions.

European fixed-income funds have benefited the most from additional central bank liquidity and improved sentiment in 1Q15. A vast majority of European funds outperformed their benchmarks, unlike other fund categories and in contrast with 2014. European high yield (HY) funds in particular posted strong positive performance (driven, in particular, by Euro Bs) and net flows in contrast with 2H14. Yet, low growth and an uncertain macro outlook have supported investor demand for investment-grade (IG) credit funds.

Performance dispersion of global funds reflects an increased regional divergence in monetary policies, growth and position in the credit cycle. Credit allocations in euros and dollars have been a key driver of return differences, particularly in HY, where divergence between the US, UK, and continental European markets have become more pronounced.

As the search for yield continues unabated, portfolio managers (PMs) are reluctantly looking for opportunities in lower rated, less liquid, off benchmark bonds, adding higher credit and liquidity risk (potentially higher currency risk), often extending duration, despite a growing consensus that the risks are beginning to outweigh the rewards.

What to Watch

Negative Convexity: Fitch Ratings expects the distribution of bond fund returns to be more negatively skewed as a result of a decline in yields and spreads coupled with increased liquidity, repricing and idiosyncratic risk.

Declining Selectivity: PMs may be tempted to overreach for yields, potentially loosening selectivity in credit and leading to excessive risk taking, as inflows continue, credit quality deteriorates and prices less reflect fundamentals.

Liquidity Risk Management: The agency considers that large (retail) funds could face a liquidity trap if they all try to liquidate their positions at the same time with no bids from (institutional) buyers. Effective embedding of liquidity risk management in portfolio construction (allocation, position sizing) and a diversified, sticky investor base would mitigate potential mismatches between assets and liabilities in the event of a sell-off.

Rating Impact: Neutral

Recent market dynamics had a neutral impact on the Fund Quality Ratings of fixed-income funds. Nevertheless, the inability to maintain discipline in credit selection and liquidity risk management may put pressure on some ratings. A potential change in market regime (characterised by higher dispersion or a prolonged bear market) or a repricing (exacerbated by poor liquidity), may lead to more differentiation between funds’ performance, which in turn could lead to selected rating actions.