The low interest rate environment since the fiscal stimulus years following the 2008 financial crisis contributed to a build-up of vulnerabilities in some segments of the corporate sector. This had been evidenced by low credit quality and high indebtedness in certain segments. In search of higher yields, funds and insurers increased their exposures to BBB-rated and high-yield bonds. BBB bonds represented a large and increasing part of non-banks’ holdings of non-financial corporate bonds.
Asset managers and investment funds are presently among the main holders of low-rated collateralized loan obligations. In the event of a sustained global economic downturn, these (often highly leveraged) companies could face difficulties in servicing their debt, with possible downgrades to high-yield bonds. This in turn would amplify the effects of a downturn through higher borrowing costs and default rates. Additionally, there are pockets of high leverage in the (alternative) investment fund sector, which could adversely impact market volatility of funds’ portfolios. High valuations (relative to fundamentals) in some asset classes may trigger further market corrections.
In this first quarter of FY 2020, rapid market declines in response to Covid-19 led to sharp mutual fund outflows after months of inflows. Funds had to sell bonds to redeem investors who caused an outflow of almost $240 billion. There was a rush out of prime money market funds, which invest in corporate debt, to the safety of government funds. The Federal Reserve through its various stimulus programs started lending money to banks so they could meet fund redemptions and started buying commercial paper to make sure companies had access to cash.
Systemic risk is rising, and some mutual funds have had to suspend redemptions due to coronavirus-driven market stress. During these uncertain times asset and fund managers should plan for how best to manage the liquidity and valuation risks in their funds. Ocean Tomo recommends that managers consider, among other aspects, the following key points:
- Periodic assessment of the portfolio structures, liquidity (cash) buffers at hand
- Review of risk and regulatory limits and monitor utilization against thresholds
- Impact assessment via appropriate stress tests that incorporate dynamic scenarios
- Monitoring processes to analyze funds investor base, behaviors, potential concentration risks
- Structuring redemption fees and charges to reduce short-term investment incentives
- Ensuring timely valuations of NAV’s, utilizing swing pricing
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