Unconstrained bond liquidity sparks financial crisis concerns

Unease comes as Gam freezes Tim Haywood’s absolute return bond fund

Unconstrained bond funds have experienced a second successive quarter of negative fund selector sentiment as a rising number of pan-European selectors seek to hold or decrease their allocations, according to Last Word Research.

Unconstrained bonds received robust net inflows last year, but our forward-looking data suggests investor appetite has weakened significantly.

The number of fund selectors looking to cut their allocation over the next 12 months has doubled to 12% in Q2 2018 from 6% six months earlier.

Moreover, 16% of fund selectors in Q2 this year were seeking to increase their allocation of unconstrained bonds over the next 12 months – a huge drop compared to the 27% in Q4 2017.

The number looking to hold has risen to 34% in Q2 compared to 29% in Q1.

Gam freezes absolute return bond fund

The slump in sentiment comes at a time when the troubles of unconstrained bond funds have been in the news.

Last week, Swiss asset manager Gam Investments froze its unconstrained absolute return bond fund following the suspension of manager Tim Haywood (pictured).

Haywood was suspended after an investigation related to risk management procedures and record keeping.

Meanwhile, the Jupiter Dynamic Bond fund has made headlines for being the root cause of the asset manager’s net outflows over the first half of the year. The Sicav fund, which has leaked over £2bn in 2018 so far, has pushed Jupiter’s total assets down 4% to £48.2bn.

Echoes of global financial crisis

Murray Gunn, senior European analyst at financial analysis firm Elliott Wave International, said the gating of Haywood’s funds could signal deeper underlying liquidity problems with the asset class.

In the build-up to the financial crisis a decade ago, US investment bank Bear Sterns liquidated two high-profile unconstrained bond funds – Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grace Structured Credit Enhanced Leveraged Fund in 2007 – before entering administration in March 2008.

“[These issues] eventually snowballed into the Global Financial Crisis of 2008. We wonder whether the world will look back on this week as having been a similar warning sign,” he said in an analysis.

Gam revealed in a Q&A update on its website that “in certain instances Haywood may have failed, in Gam’s judgement, to conduct or evidence sufficient due diligence on some of the investments that were made, or make accessible internal records of documents relating to these”. The update came a week after the Swiss asset manager’s abrupt suspension of Haywood.

“It would not be a surprise [that the fund had liquidity issues] given the frantic rush for yield over the last few years,” Gunn said.

Unconstrained bond flows

A fall in unconstrained bond flows – leading to possible liquidity issues – is supported by Morningstar European fund flow data.

Unconstrained bonds have received inflows of just €1.6bn this year, compared to a whopping €80bn in 2017.

Morningstar unconstrained bonds classification includes various categories of global flexible bond:  global flexible bond (USD hedged); global flexible bond (GBP hedged); global flexible bond (USD hedged); alternative (debt arbitrage); and alternative (long/short debt).

Source: Morningstar

The Ireland or Luxembourg-domiciled fund with the largest inflows in June 2018 was DNCA Invest Alpha Bonds I EUR at €265.9m, according to Morningstar.

It was followed by Allianz Global Multi-Asset Credit IT (€221.5m), Aviva Investors Multi-Strategy Fixed Income I (€207.1), Muzinich Enhanced yield Short-term Hedged USD Accumulation (€112.8m), and Legg Mason Brandywine Global Fixed Income Absolute Return A (€111.8bn).

The fund with the largest outflow during June was Pimco GIS Income E USD at €2.4bn. Over the last quarter, this fund has had outflows of almost €4bn.

For June outflows, the Pimco fund was followed by Jupiter Dynamic Bond I (€378.7m), Old Mutual AR Government Bond L2 (€238.8m), BlackRock Fixed Income Strategies I2 (€222.7m), and Legg Mason Western Asset Macro Opportunities Bond S (€217.2m).

Morningstar associate director for fixed income strategies, Ashis Dash, told Expert Investor that the Pimco GIS Income fund had lost the most during Q2 in terms of outflows within the category.

However, Dash noted that managers within the category were managing over €200bn, so outflows of €1bn were not a lot in relative terms.

Dash also said that his team had seen a lot of outflows within the high yield category and portfolio managers pointed to the fact that the asset class had become more expensive.

“A lot of unconstrained bond funds hold high yield bonds so that sentiment could have also impacted the flows,” he said.

Capitalising on risk

However, New York City-based Pimco CIO for non-traditional strategies Marc Seidner said there was growing interest for more dynamic, flexible, and unconstrained strategies.

Seidner said while there were valid concerns about negative returns surrounding global credit and government bond portfolios, unconstrained strategies were a good diversifier to a traditional fixed income portfolio.

He said the asset class allowed investors to capitalise on mispricing in the long and short side of interest rate risk, the long and short side on opportunities in credit risk, and volatility risk, currency risk, and liquidity risk.

“I would be concerned if a fund manager just focuses on one or two of those areas and doesn’t take into consideration the full breadth and depth of opportunities in the global bond markets,” he said.

Seidner said his team was shifting away from bigger picture macro directional views and instead was focusing on relative value and security selection.

He said he owned a little bit of duration in the US bond market and was short on many government bond markets including Italy, the UK, and Japan.

On where he was deploying capital, Seidner said US agency mortgage-backed security sector was attractive due to its liquidity, as were investment grade corporate bonds thanks to widening spreads.

“We think given how flat the US yield curve is that the prospects exists for, maybe not immediately, but a steeper US yield curve over time which would create good risk reward,” he said.

Risk management for fixed income

Seidner noted that given the heterogeneous basket of unconstrained bonds, it was important for fund selectors to thoroughly research the fund managers.

He said managers who used a good balance of top down and bottom up inputs into portfolio construction tended to show out quantitatively in better risk adjusted returns.

“When you’re managing these unconstrained more flexible benchmark agnostic strategies it’s critically important to have a robust risk management process,” Seidner said.

“When you run an unconstrained portfolio, you are the primary risk manager. Proper portfolio construction therefore needs to take into account correlation and covariance affect and stress test the portfolio on a forward-looking basis to ensure that the results in a wide variety of scenarios are appropriate.”

He said the broader challenge for fixed income portfolio managers at present was recognising that most risk premia – whether it be term premia, credit spread, or volatility risk premia –were quite narrow and unattractive globally.

“Therefore, the biggest challenge is to remain patient and wait for opportunities to present themselves rather than chasing the latest idea or theme,” he said.


Source: Last Word Research

“Throughout 2017 unconstrained bonds enjoyed exceptional net inflows. [However] in the past two quarters sentiment has fallen and there are fewer buyers across the board,” Last Word Research said.

Last Word Research surveys about 350 leading fund selectors across Europe each quarter.

In Q2 2018, unconstrained bonds were one of least popular asset classes (19th out of 26 asset classes) – a steep drop compared with Q1 when it was the eighth most popular asset class out of 22.

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