ESMA identifies possible liquidity risks in high-yield bond funds

Stress simulation framework finds “pockets of vulnerabilities” in UCITS bond funds in pure redemption shock scenarios.

Europe’s regulatory watchdog, the European Securities and Markets Authority (ESMA), has warned of “pockets of vulnerability” among EU-domiciled UCITS bond funds.

A stress simulation framework carried out by ESMA found that up to 40% of high-yield bond funds are at risk of a liquidity shortfall in the event of a large number of investors withdraw their funds within a short period of time, referred to as a pure redemptive shock scenario.

While the majority of bond funds under review would be able to cope with “extreme but plausible shocks”, those identified as vulnerable or at risk from a liquidity shortfall would require a recourse to less liquid assets should the shock scenario come to pass.

According to ESMA, between 2007 and 2018 the total net assets managed by EU-domiciled UCITS funds have increased significantly from €6.2 trillion to €9.3 trillion, necessitating vigilance from the regulatory body.

“The stress simulation framework is a key element of ESMA’s stress testing strategy, which also includes guidelines on liquidity stress testing and on money market fund stress testing. The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU financial system,” said ESMA chair, Steven Maijoor.

“This framework will be an important tool for supervisors to assess risks in the asset management industry, as the methodology developed by ESMA can be applied across the industry’s different sectors.”

ESMA stated that it will continue to run the stress simulation framework part of its regular risk monitoring to identify risk and assess possible adverse scenarios that might impact the EU fund industry.