Financial watchdog warns investors about interest rate risk to corporate bonds

27th July 2014

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The City watchdog, the Financial Conduct Authority has issued a warning to investors about the risks of corporate bond funds.

In a consumer update, the regulator outlined the risks facing bonds and bond funds – primarily,  the threat of  rising interest rates and the potential for cash-flow, or liquidity problems.

The update, published on the FCA website, asks what are the risks associated with these funds?

It then makes the following points about risk.

If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds – and the market for underlying bonds has shrunk in recent years. Fund managers manage this risk for you, by monitoring the values that can be bought and sold in each bond and limiting the size of funds’ holdings in any one bond.  

Most of the time fund managers ensure that investors are able to buy and sell their units on any day. However, in very extreme market conditions fund managers could become unable to sell sufficient quantities of bond holdings to fulfil redemption orders, leaving investors unable to sell fund units.

Interest rate movements have an impact on corporate bond and fund unit prices. So for example, as interest rates rise, bond prices fall. This is the key difference to deposit accounts, where the capital value is constant.

Corporate bond funds mainly invest in bonds where the risk of default is low. However, company defaults can impact the level of returns generated by the funds. An unexpected default reduces income and the capital value of a bond holding. Also, market expectations about economic conditions and the likely number of corporate defaults drive bond and fund prices.

The FCA says investors should consider whether they can withstand losses, do due diligence before any investment and if investors do not understand the bonds seek professional advice.

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