Up to 40% of high-yield bond funds in Europe could experience a liquidity shortfall under a severe scenario, the European Securities and Markets Authority said as it unveiled a stress simulation framework for investment funds.
The EU securities markets regulator said it simulated a pure redemption shock characterized by a large number of investor requests to cut or withdraw funds within a short period of time. The tests found that most funds are able to absorb extreme but plausible shocks as they have enough liquid assets to meet investors' redemption requests, although pockets of vulnerabilities were identified, particularly for high-yield bond funds, according to ESMA.
The regulator also modeled the impact of funds' liquidation on financial markets as they need to sell assets to meet redemption demands, thereby exerting downward pressure on assets prices. Results showed limited overall price impact for most asset classes, but there could be a material impact ranging from 150 to 300 basis points for high-yield and emerging markets bonds, among other asset classes with limited liquidity.
The regulator noted that it is important to ensure the fund industry's resilience as its development has provided provided retail and institutional investors with a range of investment vehicles, with total net assets managed by Undertakings for the Collective Investment in Transferable Securities, or UCITS, funds increasing significantly to €9.3 trillion from €6.2 trillion between 2007 and 2018.
The ESMA, which earlier disclosed final guidelines for the liquidity stress test of investment funds, will use the stress simulation framework as a part of its regular risk monitoring to identify threats and potential adverse scenarios for the EU fund industry.
The exercise followed significant inflows at some funds operating in Europe. In July, H2O AM LLP, a unit of French investment bank Natixis, suffered significant redemptions totaling roughly €8 billion amid concerns about its exposure to illiquid bonds of businesses backed by German businessman Lars Windhorst. High-profile fund manager Neil Woodford, meanwhile, suspended in June its his flagship £3.7 billion equity income fund amid growing client withdrawals.
