Could Brexit batter bond as well as property funds?

Since the financial crisis, liquidity in the corporate bond market has been squeezed due to investment banks retreating from the market, resulting in far fewer buyers for corporate credit. The corporate bond market is priced to perfection and some fear that a sudden mass exodus of investors could result in bond fund investors finding themselves trapped in their funds.

Adrian Lowcock, head of investing at AXA Wealth, argues that this is a highly unlikely scenario, because bonds are easier to sell than large chunks of bricks and mortar. He also points out that bond funds are more diversified. “Property is fundamentally illiquid,” he says. It takes a long time to find a buyer and you cannot break a building down in order to sell it, whereas bonds, like shares, can be traded in fractions.”

Patrick Connolly, certified financial planner at Chase de Vere, adds: “I would be very surprised to see what has happened to property funds happen in mainstream equities or fixed interest because generally there is far more liquidity with those assets than there is with property.”

Rob Ford, founding partner of fixed income specialist fund house Twenty Four Asset Management, also points out that with commercial property "there is no dealer community and agency brokers helping you to meet the request, so selling a property is not a five minute job."

A key difference between a bond fund and, for example, Aberdeen UK Property fund (GB00BTLX1G31), which was forced to temporarily close to redemptions in July, is that the latter has just 79 holdings compared with a strategic bond fund, which might have as many as 400 separate holdings. These are likely to be in a wide range of different sectors and have different maturities, and the funds’ managers should be able to sell some of these to meet redemptions.

Mr Ford points out that even at the worst points of the financial crisis, when high-profile property funds such as the one offered by asset manager New Star were forced to shut down, most bond funds continued to trade – albeit at unpleasant prices.

"We have never had to halt redemptions in any way, shape or form," he says. "Although in some funds we have a swinging bid – the ability to move from offer price to bid price – we’ve never even had to invoke that.

"Prices (for our fund) were lower during the crisis, and while you might not have liked the price and it might have been lower the following day, you could always trade it."

However not all bond funds were immune by any stretch. Highly leveraged bond funds made up of derivative-riddled junk debt did close to investors, and it is those assets that are widely associated with the roots of the financial crisis. But the bond funds you are likely to hold today are a different animal. Not only are they less leveraged, but regulation has cleaned up the market in asset-backed securities since.

Despite that, wealth managers are nervous about decreased liquidity.

"When we're looking at fixed-income funds, one of the areas we ask managers about is liquidity," says Mr Connolly. "So it is more firmly on our radar than it used to be when assessing funds and its something the regulators have been looking at too. Retaining liquidity is a case of looking at the assets managers are invested in and making sure that they have a spread which would allow them to sell assets at short notice at the right prices."

Mr Ford agrees that it is no longer possible to trade any bond in five minutes, but adds:"There are still 25 investment banks that I could phone today to ask for bids on bonds, and each of those has a plethora of other clients they can go to (for bids)."

Funds to get around liquidity issues

The best way to avoid bond liquidity issues is to hold an active bond fund with a remit to move between asset classes, so it can allocate to the ones which are the most appealing at the time. "If you are invested in a particular bond sector then you have more concentration risk, so if there is an issue in that area it will hurt you more," explains Mr Connolly. "If there are going to be risks those will likely be in high-yield or emerging markets, or at the lower quality end of the corporate bond space.

"Strategic bonds funds, which can invest across a broad range of bond sectors and move between them according to risk, have the flexibility to avoid or at least reduce liquidity risk. Fixed income is very expensive at the moment too, so we want to use a manager that we feel is better placed to make the right call and has the flexibility to do that."

Mr Connolly likes the Kames Strategic Bond (GB0033988543), Henderson Strategic Bond (GB00B03TP539) and Jupiter Strategic Bond (GB00B4T6SD53) funds.

Kames Strategic Bond Fund is invested across a broad range of fixed-income sectors, including government bonds, emerging market debt and asset-backed securities. Since launch, the fund is ahead of the Investment Association (IA) Strategic Bond sector, but in recent years it has slipped behind due to the managers’ insistence on keeping interest rate risk to a minimum. With rates remaining low, this has not benefited the fund in the short term, however fund research company Morningstar says: "We continue to place faith in the team."

Henderson Strategic Bond, an IC Top 100 Fund, has fared better, returning more than 34 per cent over five years – exceeding the sector average. The fund invests in higher-yielding assets, including high-yield bonds, investment-grade bonds, preference shares and other types of bonds, with 202 holdings in total. Investment-grade non-financial corporate bonds make up the largest chunk of the fund, at just over 35 per cent. However it also uses derivatives in order to hedge and smooth returns.

A more cautious option which aims to limit downside in tough markets is Jupiter Strategic Bond managed by Ariel Bezalel, also an IC Top 100 Fund. Research company FundCalibre says: "Mr Bezalel aims to achieve capital growth, although in practice he is prepared to sacrifice the yield in order to preserve capital."

The fund has double the number of holdings that Henderson Strategic Bond does, at 411, and is also well diversified across bond assets. It holds bonds with a higher credit rating than Henderson – more than 25 per cent of the fund is invested in AAA-rated debt, which may yield less but should be easier to sell in times of stress.

Mr Lowcock highlights M&G UK Inflation Linked Corporate Bond (GB00B460GC50), which invests in corporate bonds but hedges against inflation."There aren't that many listed inflation-linked corporate bonds, so its manager buys the ones there are, and creates liquidity using swaps and derivatives," he says.

But Mr Connolly says: "Those funds invested in index-linked bonds haven't done well recently because inflation has been so low. We prefer to hedge against inflation with a balanced portfolio that includes growth assets expected to outperform."

Do ETFs get around liquidity issues?

In a word, no. No fund, however clever, can ultimately be more liquid than the assets it holds. But you should be able to sell out of an exchange traded fund (ETFs) in a time of stress faster than a mutual fund.

That is because ETFs trade on a secondary market, like shares, and are priced throughout the day. Most trades can be completed without any need to deal the underlying bonds.

ETFs also benefit from traders called authorised participants and market makers, who maintain a market for ETF deals even in times of market stress, albeit at a price. Authorised participants can create and redeem new ETF shares in response to demand, and market makers are a group of traders who are theoretically always willing to offer a price for an ETF. This strata of the market means that it is usually possible to get a price for an ETF even during the worst times, although that price could be very different to the value of the underlying assets.

It also means that you are unlikely to be trapped in an ETF, even if the underlying market is freezing up. In the worst possible scenario, market makers could still refuse to buy ETFs, or charge punitive prices for doing so, however this has not been the case in volatile periods up to now, including during the last financial crisis when trading of bond ETFs continued as normal – even as the underlying market dried up.

"Let's say you are an investor in a mutual fund and your friend is invested in an ETF," says Howie Li, co-head of CANVAS, ETF Securities. "In the morning something shocks you both and you want to sell. You, as the mutual fund investor, have to put in a redemption form and say you would like to close by the end of business. You don’t know what price you will get, and whether or not the funds will be gated. Your ETF friend decides to sell, receives a quote and is out immediately.”

One of the downsides of using ETFs is that you have to choose a specific market to back. This differs to the active bond space, where a strategic bond fund manager is able to hold several different kinds of bond depending on which offers best value at the time.

Active management is creeping into the bond space though. Key examples include ETF Securities and Lombard Odier's range of fixed income ETFs. By screening issuers for credit quality and other factors instead of weighing bonds by market cap, and so being most exposed to the most indebted issuers, their ETFs are likely to be less vulnerable to default risk than comparable funds. This range includes ETFS Lombard Odier IM Emerging Market Local Government Bond (LOCG).

The biggest bond fund outflows

Source: Morningstar, as at 20.07.16. Open-ended and ETFs fixed income funds domiciled in Europe, global fixed income sectors

Biggest bond fund inflows

Source: Morningstar, as at 20.07.16. Open-ended and ETFs fixed income funds domiciled in Europe

Largest bond sectors in total net assets

Source: Morningstar, as at 20.07.16. Open-ended and ETFs fixed income funds domiciled in Europe

Cumulative total returns (%) from suggested open-ended bond funds

Source: FE Analytics, as at 25.07.16

Annual calendar total returns (%) from suggested bond ETFs

Source: FE Analytics, as at 25.07.16