European emerging-market bond funds pose limited contagion risk to the broader financial system in light of the conflict in Ukraine, rating agency Fitch said on Monday. The funds have low exposure to Russia, Ukraine and Belarus, which should limit the risk of a large increase in redemptions.
Sudden surges in redemptions from open-end fund structures can create systemic risks as forced asset sales ripple through the broader financial system. Fitch-rated European funds had no direct exposure to Russian entities at the end of January but Fitch said it is monitoring the funds for signs of spill-over effects.
Fitch analysed a sample of 19 funds with a rating, representing about 17 percent of European EM bond fund assets under management at the end of February. The funds had, on average, 5 percent exposure to Russia - 100 million euro on average, in nominal terms - but this ranged from 0 to 14 percent. The actual exposure may now be lower due to reductions made by managers due to the conflict, Fitch said.
Russia exposure inversely correlated to fund size
Exposure to Russia was typically inversely correlated to fund size, with larger funds having lower exposure. Exposure to Ukraine ranged from 0 to 4 percent, while exposure to Belarus was negligible.
“Our sample focused on aggregate bond funds - combinations of sovereign and corporate exposure - but corporate-focused funds are likely to face greater pricing or redemption pressure, particularly if they are exposed to energy or financial companies in Russia, or firms with material Russian links,” the rating agency said.
“We expect outflows from European EM bond funds to continue in the short term, driven by investor re-allocation from riskier assets to safe-haven assets, concern over Russia exposure and performance deterioration due to material price movements.”
AuM decreased significantly
Assets under management in European EM bond funds decreased significantly in the months leading up to the conflict. Fitch estimates this at 260 billion euro at end-February, down 8 percent from end-January and 13 percent from end-September 2021.
Redemption pressure may be exacerbated by near-term credit concerns. Fitch downgraded Russia to ‘C’ on 8 March, citing the possible selective non-payment of sovereign debt obligations. In the Fitch sample of funds, 90 percent of the Russian bonds have coupons due within the next six months, the largest exposure being the 5.1 percent March 2035 bond, present in seven of the 19 funds. Its next coupon is due on 28 March 2022.
Rising Warf cuts rating headroom
Fitchs said it estimates the downgrade of Russia to ‘C’ has increased the sample funds’ weighted average rating factor, or Warf, Fitch’s proprietary measure of fund credit risk, to about 22 from 19. “This is still in the ‘BBf’ range but with the effective rating headroom materially reduced,” said Fitch.
Warf is the market value-weighted sum of each portfolio security’s credit rating factor. Most of the funds had hedged their FX positions, but funds with unhedged portfolios will have been hit by the sharp depreciation of the rouble.
When funds face significant redemption requests, they will typically draw down liquid assets and they may sell portfolio securities to rebuild cash buffers, often selling more securities than needed for redemptions. Fitch said its sample funds averaged 5 percenet in liquid assets at the reporting dates, ranging from 0 to 11 percent. Most of this was in cash. The rest was in money market funds, used as a liquidity source by four of the funds.
“Sustained redemptions could, therefore, lead to modest MMF outflows, but MMFs could, at the same time, benefit from inflows from investors that view them as a safe haven,” Fitch said.
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