In late July, the Financial Conduct Authority (FCA) published “some important considerations” for existing and potential investors in corporate bond funds. Quite what prompted the FCA to do so was not made clear: the Sterling Corporate Bond fund sector has been the worst seller in terms of net retail sales for six of the last twelve months according to the Investment Management Association.
The FCA spelt out three risk factors for investors to consider:
- Liquidity This was probably the FCA’s reason for issuing the statement. The popularity of corporate bond funds has been accompanied by concerns about shrinking bond market liquidity. On both sides of the Atlantic, regulatory pressures have forced investments banks to cut back or withdraw completely from bond trading activities. This has not caused any major problems to date, but in the US the Federal Reserve, among others, has expressed concern about what might happen if a sudden rush of sellers finds no buyers. The FCA notes that “in very extreme market conditions fund managers could become unable to sell sufficient quantities of bond holdings to fulfil redemption orders, leaving investors unable to sell fund units.”
- Interest rate risk “…as interest rates rise, bond prices fall,” said the FCA. This is basic investment mathematics, but it would have helped if the FCA had explained that not all ‘interest rates’ are the same. A rise in base rates (see “Interest rate hokey cokey”) will not necessarily mean a fall in corporate bond prices. Markets always try to anticipate events, so by the time the Bank of England does eventually dispense with a 0.5% base rate, prices will almost certainly have allowed for the rise (and possibly several more to come afterwards).
- Defaults If the number of companies defaulting on their bond payments increases or appears likely to do so, then corporate bond values and hence corporate bond fund prices will fall. Defaults are currently at historically low levels, thanks to low interest rates and plenty of cash looking for a home. If interest rates rise across the board, the default picture could become less rosy.
This trio of risks is well understood by bond fund managers, although naturally they have different views on their potential impact. This feeds through to the way in which their funds are managed. To quote the FCA again, “…it is essential to perform due diligence on individual funds to assess whether their investment strategies meet your requirements.”
Let us know if you think you may be affected.