The downturn in the bond market that began in late September has exposed significant risks associated with short bond funds, particularly those characterized by style drift, credit deterioration, and extended maturitiesSome of these funds have found themselves ensnared in a vicious cycle of redemptions, forced sales, and plummeting values, causing a continuous decline in their performance, with net asset values still failing to recoverDespite having gained popularity as “celebrity funds” due to high returns earlier in the year, these funds have seen massive redemptions as investors have turned away.

Several industry insiders in the public bond market have highlighted that managing short-term bond products requires a careful balance of duration risk, credit risk, and liquidity riskThey caution that seeking higher yields cannot come at the cost of extreme exposure to any single risk factor

With spreads compressed to extreme levels, excessive credit downgrades and extended durations are deemed unwise strategies.

The current focus, according to these experts, is on liquidity managementIt is crucial not only to account for liquidity premiums but also to increase attention to market risk preferences, study investor behavior, and adapt quickly to shifts in market funding flows.

The drift in investment style has led to this negative feedback loop.

Since the end of September, a series of policy actions aimed at revitalizing the economy sparked a significant rebound in the A-share market, raising overall market risk appetite and resulting in broad gains across mainstream equity indicesConversely, the bond market has faced considerable pressure, experiencing a pronounced correction due to a “stock-bond seesaw” effectEven funds that are typically low-risk with good liquidity and relatively stable returns were not immune, witnessing daily declines exceeding 30 basis points.

The profitability of the equity market has also siphoned off substantial capital from the bond market

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According to data from Wind, the total scale of short-term pure bond funds plummeted by over 200 billion units in the third quarter alone, marking the highest quarterly redemption figure since the beginning of 2023.

Amidst the broad increases in stock prices, rotation among sectors and styles occurred as the market shifted to a phase of searching for key themesIn the context of continued monetary policy easing, the bond market gradually stabilized, with interest rates entering a downward trajectory, leading to a recovery in the performance of fixed-income products.

However, an analysis reveals that as of November 15, nearly 15% of short bond funds have yet to recover their net asset values to levels seen before September 24. During this period, some short bond funds have incurred losses exceeding 100 basis points, struggling to regain their footing.

For instance, one particular short bond fund with a rolling 60-day holding period demonstrated a troubling trend, recording losses in 7 out of 8 trading days since late September

A once highly-acclaimed short bond fund faced massive redemptions in the third quarter amounting to billions of units, yet it continued to decline over 8 consecutive trading days even after the bond market showed signs of stabilization in late October.

Industry insiders attribute the persistent downward spiral of these short bond funds to a dramatic shift in investment style aimed at maximizing returns and fund scaleSome funds engaged in risky behaviors like excessive credit deterioration and significant duration extension, leading to initial outperformance compared to peers; however, once the market corrected, these funds severely underperformed.

As net asset values plummeted, these bond funds encountered significant redemptions, forcing managers to liquidate illiquid securities at distressed pricesIf these securities have longer durations while simultaneously holding lower credit ratings, market sentiment can worsen, leading to a situation where there are no buyers for the offered bonds

Consequently, fund managers might resort to steeply discounting prices to sell these bonds, perpetuating a downward cycle in net asset values and continuous redemptions from investors, resulting in significant detriment to overall portfolio returns.

Long Yuefang, General Manager of Fixed Income at Jin Ying Fund, confirmed that while interest rate bonds began to stabilize mid-October, credit bonds have been slow to recover due to market caution stemming from certain related policies, particularly affecting lower-quality city investment bonds.

The importance of managing liability sides is increasingly recognized.

Reflecting on the bond bull market trends from 2019 through the third quarter of 2024, Lin Ping, a fictitious name for a manager at a mid-sized public bond fund, indicated that duration strategies had historically provided substantial excess returns for fixed-income products

However, following the downturn in late September, those same duration strategies have struggled to generate sustainable excess returns, leading to a decline in the average duration for short bond funds.

Research from the fixed income team at Debang Securities highlights that short bond fund performance was relatively weak in the third quarter, with a sequential reduction of 226.6 billion yuan, representing a 15% declineFunds predominantly held by institutional investors saw even more significant drops in count, with greater median drawdownsBy the end of the third quarter, the leverage ratio of short bond funds decreased from 113.27% to 113.20%, and the duration of high-concentration securities fell from 0.69 years to 0.64 years.

“Managing short bond products entails a balanced approach to duration risk, credit risk, and liquidity riskIt is unwise to excessively expose to any single risk factor solely for the purpose of enhancing yield

If the credit composition is leveraged in pursuit of yields while selecting illiquid bonds, there may be a point where potential returns outstrip the risk of losses, yet volatility acts as a controlling factor which could lead to severe retractions during market turbulence,” confessed Lin, noting that this has been an overarching issue for many short bond funds since September’s turmoil.

According to Long Yuefang, following this round of adjustments, the importance of liquidity management seems to have significantly increased, particularly for mid-to-short duration funds.

“When spreads are maximally compressed, a swing towards excessive credit downgrades and extended durations should be approached with cautionEarning excess returns cannot solely rely on credits' downgrades; rather, a comprehensive approach involving multiple trading strategies, such as long-end wave trading, spread trading, and asset rotation to manage exposure is vital,” Long advised.

Lin Ping maintains that in the current environment, where the yield curve is relatively flat and uncertainties abound, if a fixed income product has strict performance drawdown requirements, its overall duration should revert to safer positions

Furthermore, the selection of bonds must align with changes in spread situations, adapting to market sentiment fluctuations efficiently“For instance, when credit spreads were compressed to extreme levels in the third quarter, lower-rated credit bonds should pivot to higher-rated bonds, certificates of deposit, or high-liquidity debt to both mitigate large drawdowns and manage redemption risks,” he further elaborated.

Huxueqi, a fund manager for Yongying Fund's fixed-income investment division, echoed this perspective, emphasizing that pure bond products, especially short-bond funds, should always prioritize asset liquidity and adjust portfolio duration, leverage, and structure according to changing asset scale conditionsWhen employing credit downgrade strategies to acquire credit premiums, it is essential to consider potential liquidity trade-offs on the liability side.

Recent fluctuations on the liability side have made many fund managers passive in their bond fund management practices

Observations across the industry reflect that particularly for short bond funds aimed at retail investors, a sudden drop in fund values may lead some investors to hold their positions, but prolonged declines can trigger low-risk tolerance investors to surrender quickly, causing a wave of redemptions.

Thus, in this currently unpredictable environment marked by ongoing fluctuations, effective liability side management becomes one of the primary tests for fixed-income fund managersWhen narrowing liquidity on the liability side occurs, short-end products face redemption pressures; diminished scales pose challenges to product management and investment strategies.

In terms of managing the liability side effectively, Long Yuefang proposes a twofold approach: first, understanding the composition of liabilities—including retail, bank, insurance, and wealth management—gathering insights into diverse liquidity needs from various clientele by establishing communication initially; second, bolstering research on both institutional and retail behavior to pre-emptively gauge market changes and adjust the liquidity ratio of portfolio assets and corresponding duration leverages accordingly

Timely adjustments to duration assets are necessary during adverse market developments, enabling swift reduction of both duration and leverage to smooth product volatility.

As reported since late October, the pressure of redemptions on bond funds has begun to ease, with Long Yuefang noting that the significant wave of redemptions seems to have peakedInitial data suggests that bond funds have resumed net subscriptions since early November.

“Though large redemptions have become less frequent recently, there is a structural change within the existing scale of bond fundsCertain investors, based on past performance, are transitioning funds from previously underperforming products toward those achieving stronger results,” said Lin PingFurthermore, he pointed out, “Market information asymmetries have been diminishing, with investors learning through varied channels how to evaluate bond market trends, subsequently modifying their subscription actions

Retail and institutional investor priorities differ concerning earning models; retail investors react sensitively to losses, and quick redemptions are likely if perceptions turn negative, leading retail investors to emerge as a robust force in the market.”

Lin concluded that currently, bond funds have not rebounded to previous states of extensive net subscriptions, and funds from wealth management channels have yet to experience the rapid inflow reminiscent of previous yearsMoving forward, the stability of the liability side in the bond fund sector will remain critically tied to the performance of the equity market.

Consequently, Long Yuefang believes that going forward, liquidity management will remain a central focus for fixed-income product strategiesWhen determining foundational holdings, it is essential to account for liquidity premiums while amplifying considerations of market risk preferences, deepening studies of institutional actions and retail behaviors, and keeping an eye on shifts in market funding flows.

In recent years, the continuous decline in bond yields has led to increasing market volatility

One executive from a public fund’s fixed income department noted that interest rate declines inherently amplify perceived volatility; moreover, risk events among high-yield investments, such as municipal investment bonds, trigger significantly more pronounced market fluctuations than before.

“Historically, coupon yields provided a cushion for bond funds’ performance; however, as coupon earnings have diminished, capital gains now substantially influence yields within bond portfolios, making volatility more readily apparent in fund net values,” he concludedAs bond market earnings decrease and volatility escalates, it is recommended for credit bond combinations to adopt a barbell strategy that incorporates both short and long assets; meanwhile, a balanced duration level should be maintained for interest rate bonds, utilizing active long-end securities for frequent trading