European emerging market bond funds have limited contagion risk, says Fitch


European emerging market bond funds present limited contagion risk to the financial system as a whole in light of the conflict in Ukraine.

Data shared by Fitch Ratings showed that due to the funds’ low exposure to Russia, Ukraine and Belarus, the risk of a surge in redemptions is limited.

The ratings group said sudden increases in redemptions from open-ended fund structures have historically created systemic risks, as forced asset sales ripple through the entire financial system.

European funds rated by Fitch currently have no direct exposure to Russian entities as of the end of January 2022. However, but confirmed that it is monitoring the funds for signs of ripple effects.

Using analysis of a sample of 19 funds (not rated by Fitch) representing approximately 17% of the European Emerging Markets Bond Fund’s total assets under management, as of the end of February 2022, it found that the funds had , on average, a 5% exposure to Russia. That is an average of 100 million euros in nominal terms.

However, this ranged from 0% to 14% based on various data through the end of January 2022. Fitch said actual exposure may now be lower due to cuts made by managers in anticipation or in response to the conflict. .

This contrasts with the equity market, where Fitch recently pointed out that as much as €3 billion was trapped in frozen funds from Russia and emerging Europe.

Commenting on the bond market, a Fitch spokesperson said: “Exposure to Russia was generally inversely correlated to fund size, with larger funds having lower exposure. Exposure to Ukraine ranged from 0% to 4%, while exposure to Belarus was negligible.

“Our sample focused on aggregate bond funds (combinations of sovereign and corporate exposures), but corporate-focused funds are likely to face greater pricing or redemption pressure, particularly whether they are exposed to energy or financial companies in Russia, or companies with significant Russian ties.’

According to Fitch, outflows of European bond funds from emerging markets are likely to continue in the short term, due to the reallocation of investors from riskier assets to safe-haven assets, concerns about exposure to Russia and deteriorating performance due to large price movements.

Assets under management for European emerging market bond funds fell significantly in the months leading up to the conflict, with Fitch estimating €260 billion in assets under management at the end of February, down 8% from the end of January and 13% compared to the end of September 2021 (see graph below).

Downgraded Russia

In addition, repayment pressure can be exacerbated by short-term credit issues. Fitch downgraded Russia to “C” on March 8, citing possible selective nonpayment of sovereign debt obligations.

Analysis of the sampled funds shows that 90% of Russian bonds have coupons due within the next six months, with the largest exposure being the 5.1% March 2035 bond, present in seven of the 19 funds. The next coupon is due March 28, 2022.

Fitch estimated that Russia’s downgrade to “C” raised the sample funds’ weighted average rating factor (WARF, Fitch’s proprietary measure of fund credit risk) to about 22 from 19.

It’s still in the “BBf” range, but with noticeably reduced effective headroom. WARF is the market value weighted sum of the credit rating factor of each security in the portfolio. Most funds had hedged their currency positions, but funds with unhedged portfolios will have been hit by the sharp depreciation of the rouble.

The funds in the sample had an average of 5% liquid assets at the closing dates, ranging from 0% to 11%. Most of that (4pp) was cash. The rest was in money market funds (MMFs), used as a source of liquidity by four of the funds.

Subsequently, sustained redemptions could therefore lead to modest outflows of money market funds, but money market funds could, at the same time, benefit from the inflows of investors who consider them a safe haven.


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