Growth in global bond fund assets, coupled with shifting market conditions, has Fitch Ratings warning that bond funds represent an increasing risk to financial stability.

In a new report, the rating agency says open-ended bond funds have become “a potential risk to global financial stability given their rapid growth and increasing liquidity mismatches and credit risk.”

Fitch says that investment in open-ended bond funds has surged since the global financial crisis, thanks to factors such as the prevalence of historically low interest rates and tougher bank regulation. It reports that the latest data from the Financial Stability Board shows that investment funds (including open-ended and other fund types) grew by an average of 12.3% annually between 2008 and 2016, and that assets under management in bond funds grew to a high of almost US$11 trillion last year.

“Open-ended bond funds provide daily liquidity for investors but are increasingly investing in longer-dated or lower-quality securities as bank regulation has reduced the supply of market liquidity and investors are seeking extra yield while interest rates remain low,” it says. “This exposes funds to liquidity pressure if there is a spike in redemptions, potentially leading to forced asset sales and a run on the fund as investors pull out.”

This sort of stress could, in turn, spread throughout the financial system, Fitch says, due to connections between funds, banks, non-bank financial institutions (NBFIs) and the rest of the financial market. “Transmission to other institutions could be as a result of market value declines in the types of collateral that they have in common with the funds. Banks and NBFIs could also be exposed through their short-term funding reliance on the funds or other counterparty exposure to them,” it says.

So far, Fitch reports, redemption pressure in open-ended bond funds has been “limited,” although it notes that outflows from high-yield funds increased last year. It adds that the risk of a run on bond funds is most pronounced in purely credit-focused funds that have less-liquid underlying assets. It estimates that these sorts of funds represent about 15% of total global bond funds.

As to whether regulators are prepared to deal with these risks, Fitch says, “increased fund regulation, such as stress testing, may help identify sources of run risk, but does not remove them.”

“High redemption activity could test extraordinary liquidity management tools, such as limiting or suspending redemptions,” it says. “These tools have helped to contain open-ended fund stress to individual funds or fund sub-sectors in the past, but there is a risk that gating could spark contagion to other funds if it disrupts market confidence.”