• High-yield debt concentrated in funds with redemption risk
  • Mismatch in liquidity of funds and bonds creates instability

High-yield bonds and loans may suffer more in a downturn than in previous crises because they’ve become concentrated in funds that allow early redemptions, according to UBS Group AG.

More than 50 percent of high-yield bonds and 35 percent of leveraged loans are held by funds with “significant redemption risk,” UBS strategists Stephen Caprio and Matthew Mish wrote in a note to clients, citing data through the end of last year. Mutual funds have increased their holdings by $1.4 trillion since March 2009, exceeding a $1.2 trillion increase in outstanding corporate debt, according to the report.

“The market is in less steady hands,” the strategists wrote. “The amount of corporate credit owned by fund structures that are highly susceptible to a ‘first mover’ redemption risk has ballooned since 2009.”

Concerns are growing that a mismatch in timing between investor redemptions and funds’ ability to sell bond holdings could worsen a selloff. Federal Reserve Bank of Dallas President Robert Kaplan said this week that mutual funds and exchange-traded funds create instability because they offer daily liquidity, even though it can take longer to sell bonds, and Third Avenue Management LLC roiled the market last year, when it said it couldn’t meet outflow requests because of illiquidity in the securities.

Redemption Risk

U.S. mutual funds, foreign investors and exchange-traded funds were major sellers of corporate bonds during the financial crisis in 2008, the strategists wrote. Funds that face redemption risk increased their holdings of leveraged loans to 35 percent from 19 percent in 2009, according to the report. 

At the same time, hedge funds and private-equity investors, which support the market by buying at distressed levels, have reduced credit holdings, they wrote. Investment-grade credit is less risky because only 20 percent is held by funds that are prone to outflows, the report shows.

“If some bonds in a certain fund are not liquid enough to trade daily, then does it make sense to offer a client daily liquidity in that fund?” Sebastien Eisinger, chief investment officer of fixed income at Pictet Asset Management wrote in a report this month. “It is a mismatch that can cause problems.”

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