Bond fund investors should beware a crowded market where there is a growing risk of being caught out by a sharp sell-off in fixed income, analysts at RBS have warned.
In a note to investors, the bank's credit team said liquidity across credit markets - something it measures using its own internal process - has fallen by 70% since the 2008 crisis.
Looking at liquidity in terms of trading volumes, transaction costs and market depth, RBS said trading liquidity is now "evaporating" out of bond markets.
While policymakers focus on banks' exposure to markets, RBS' team of analysts said this approach is as misplaced as the ‘Maginot line’ – the interwar fortifications designed to prevent another German attack on France - because it ignores the fact investors in funds and ETFs are now as interconnected to the financial system as banks.
The report said: "The recovery in credit has been about low rates pushing capital into risky assets and helping firms to refinance. This has made bond markets ‘the new banks’, providing most credit to the economy. But it has also pushed investors to take higher risks.
“What happens if low-for-long policy reverts and investors head for the exit? As regulators focus on banks, we fear that systemic risk is being left unchecked in financial markets.”
It warns a number of bond funds in the US and Europe, as well as ETFs, are now running very concentrated positions in bonds which are smaller and illiquid. These were picked up by bond investors because of the yields on offer, but these yields have now eroded, with investors no longer paid to take liquidity risk.
The analysts warned, as a result, the redemption risks for many of the funds are building dramatically.
"Given the banks' reduced ability to produce liquidity, we think there is a risk mutual funds and ETFs could face large redemptions and a limited ability to sell assets if the market turns, worsening a sell-off."
Managers including Investec's John Stopford and Gareth Isaac, manager of the Schroder Strategic Bond fund manager, warned last year liquidity had become worse in bond markets, with investors selling what they can rather than what they want.
Moves by central banks to provide ongoing stimulus have thus far prevented this from materialising.
Nonetheless, the note highlights an important trend in fixed income markets; namely that now the banks have been forced to reduce their exposure, asset managers - and ultimately retail investors - have taken up much of the slack, leaving them more exposed than ever to any sell-off if sentiment turns.
The high concentration of retail ownership of many bonds increases the risk of a “feedback loop” according to RBS' analysts, an event which would see investors pull out their money and funds forced to sell holdings to meet redemptions, in turn sparking panic and seeing more investors head for the door.
The note found similar trends in Europe as the US, where the 15 largest funds hold between 15% and 20% of the total issuance for the five most commonly held bonds.
Earlier this year, Investment Week reported corporate bond fund managers were seeking to avoid deals dominated by their larger peers to avoid just such a problem.
Last week the Financial Conduct Authority also sent a stark warning to consumers about the risks of investing in corporate bond funds, stressing that they are far from risk-free investments.
