Moody's Investors Service outlook for the credit quality of bond funds remains stable reflecting issuers' creditworthiness underpinned by positive underlying factors, including the significant amount of liquidity held by corporations, strengthening capital in the banking sector and a less risky, if subdued, global economic outlook.
The new report – 2015 Outlook – Bond Funds: Stable Credit Strength; Buffeted by Market Volatility – reveals that sharp credit deterioration in bond fund portfolios will be limited in 2015. Moody’s expects the global speculative-grade default rate to remain low, ending 2014 at 2.3% before increasing slightly to 2.7% by end of 2015. However, issuers rated B3 negative or lower continue to show that several companies' capital structures remain stretched; of these Moody's does expect some defaults.
"We know that investors will need to adjust to poorer liquidity and higher costs for trading because market liquidity will remain exacerbated. Liquidity in the bond market has plummeted in recent years, which has led to higher market volatility. To some extent, investors had become complacent about trading costs; with the sharp deterioration in market liquidity, investors will need to be more savvy of the cost of buying and selling a security, which has increased significantly in the last few years," says Soo Shin-Kobberstad, a Moody's Vice President and co-author of the report.
"We expect net inflows in bond funds to remain marginally positive in 2015. However, as risk aversion is increasing, investors may rethink their asset allocation and shift out of long-duration bond funds and into those with flexible mandates and shorter durations, which will better insulate portfolios from an interest rate rise. Investors, such as pension funds and insurance companies, will continue to rely on fixed income investments to provide reliable income and steady returns, even in the face of higher interest rates," says Marina Cremonese, a Moody's Assistant Vice President and co-author of the report.
Furthermore, Moody's believes that new money market fund (MMF) regulations in the US and proposed MMF regulations in Europe will drive assets into very short-term bond funds. The changes to product structure in the US will likely cause investors to significantly reduce exposure to prime money market funds. MMF investors will shift portions of their cash balances to alternative liquidity products, and short duration bond funds will benefit from this trend.
