OREANDA-NEWS. Fitch Ratings says it is unclear whether asset managers' greater focus on liquidity management techniques would be enough to match redemption demands in the event of severe market stress, as liquidity has declined in the fixed income markets, with central banks rather than banks and broker-dealers now providing a liquidity buffer.

Liquidity risk was a key topic at Fitch's "The Changing Landscape of European Credit Markets" events in London and Paris in late October. Over 80% of delegates viewed it as a systemic issue needing an industry wide solution, given the majority of credit funds continue to offer investors the ability to redeem their fund holdings daily.

As an example, 96% of UCITS corporate credit funds provide liquidity on a daily basis as of September 2015, with settlement typically one day after the redemption request. This is despite the fact that UCITS rules provide for a minimum redemption frequency of twice monthly and allow for settlement up to 10 days after the redemption request has been received.

The potential commercial consequences through fund outflows of being a 'first mover' away from daily liquidity are likely to stymie fund provider appetite for adjusting fund liquidity terms. Instead, additional regulatory scrutiny of liquidity risk management may instead be a driver for change. In the US, the SEC recently proposed new liquidity management requirements for retail mutual funds. (see Fitch: US liquidity Proposals May Have Unintended Consequences, 09 Oct 2015).

Outflows from UCITS corporate credit funds have not affected all fund segments or been precipitous as yet. Total assets have remained flat since end-December 2014 (in EUR terms), according to Lipper data. Outflows have been strongest in emerging market corporate credit funds, while European high yield funds continue to see inflows.

We see some evidence of fund flows following returns. In the US high yield fund sector, outflows followed weak performance in 1H11, 2Q13, 3Q14 and this trend has repeated itself since the middle of this year. The performance of fixed income fund categories year to end-October has been mixed and volatile, as USD and euro corporate credit markets diverge and a negative emerging market sentiment weighs on developed markets. For example, global investment grade funds lost 4.8% (in USD terms) while European High Yield funds gained 2.2% (in EUR terms).

Across the universe of funds Fitch rates we see a greater focus on liquidity management techniques, in response to market conditions characterised by more frequent, episodic bouts of volatility, as observed in Bund pricing for example, in periods of parched or absent liquidity.

On the liability side, liquidity risk management tools may include position sizing and diversification rules limiting, for example, the maximum percentage ownership of a given security, or the maintenance of specific cash balances. Fund managers may also actively use derivatives (such as total return swaps) as a liquidity risk management tool, although the active usage of derivatives can change the profile of a fund and, more fundamentally, any downside protection achieved through a derivative-based strategy may limit upside potential. Lastly, fund managers are paying closer attention to trade execution and cost.

On the asset sides, fund investors will typically limit their maximum holding in a fund to 10% or less of its total assets, a rule which fund providers will also typically apply.