OREANDA-NEWS. Flow volatility in European high yield (HY) bond funds has risen to a two-year high, suggesting investors are willing to pull out more money and at a faster rate, Fitch Ratings says. This highlights the increasing importance of liquidity risk management for HY funds to ensure they can meet redemptions during a material market liquidity event.

Volatility measured as six-month rolling standard deviation of flows of assets under management rose to 3.36% in March/April, based on data from Lipper, and is now at its highest level since November 2013. This is much higher than for investment grade (IG) bond funds, where volatility is 0.11% and has changed little. European HY bond funds hold about 13% of issued European HY bonds, against just 5% of IG issuance for IG bond funds. This means large-scale redemptions can have a bigger market impact than for IG funds, increasing the risk of a vicious circle of outflows, driving falling prices and further outflows.

To mitigate these risks, HY funds tend to hold higher cash balances than IG funds. But market and fund-flow volatility has eroded these since the start of the year and some HY funds maintain considerably smaller cash balances than the average IG fund. Other techniques are therefore increasingly important for liquidity risk management.

Fund providers with a good understanding of investor behaviour will be better positioned to cope with liquidity stress than those with less knowledge of their investor base. Large exposure to potentially opaque investor pools, such as fund platforms, is therefore a potential risk factor. As is exposure to a handful of large individual investors, who could cause liquidity problems if they redeemed their holdings.

Actively sizing investment positions based on liquidity risk, rather than just issue size, is an increasingly important consideration in funds' investment processes. Most fund managers have, or are developing, liquidity scoring and stress testing tools. The sophistication of these tools will be important factors for investors to consider and will feed into our assessment of funds' liquidity risk management in Fund Quality Ratings.