Bond Fund Mandate Breach and Redemption Pressure
An HKD bond fund has NAV of HK$500m. Its investment mandate requires at least 80% of assets in investment-grade bonds and modified duration not exceeding 5.0. Current holdings are 92% investment grade, 8% cash, with modified duration 4.8. The portfolio includes a 10-year BBB+ corporate bond with duration 7.5 (20% of NAV) and a perpetual subordinated bond rated BBB- with a call in 2028 (10% of NAV). The HKMA raises policy rates by 75bp; the fund's NAV falls 4.2% and investors redeem HK$80m. The manager proposes selling all cash and some short-dated HK government bonds to buy a 5-year BB-rated bond yielding 7.5% (15% of NAV) and a 30-year HK government bond with duration 12 yielding 4.2% (20% of NAV). The manager argues the high yield compensates for duration and credit risk. The trustee asks for a compliance and liquidity assessment before dealing.
1. Assess whether the proposed trades comply with the fund's investment-grade and duration limits.
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On the stated funding plan, the fund sells 8% cash and 27% short-dated investment-grade bonds to buy 15% BB-rated bonds and 20% 30-year HK government bonds. The investment-grade ratio would be: 92% − 27% + 20% = 85%, so the 80% minimum is still met. The BB bond is 15% of NAV and remains within the 20% non-investment-grade bucket.
However, modified duration would be: 4.8 − (0.27 × 1) + (0.15 × 4) + (0.20 × 12) = 7.53. That exceeds the 5.0 limit. The trades cannot be executed as proposed. The manager must reduce the 30-year allocation, shorten duration, or use permitted hedging if the mandate allows derivatives. The perpetual BBB- bond also carries call risk: if not called, the coupon resets and duration extends, and a one-notch downgrade would move it to high yield, further testing the 80% limit.
2. What liquidity and redemption risks arise from the HK$80m redemption, and what should the trustee require before dealing?
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The redemption is HK$80m, or 16% of NAV, while cash is only HK$40m (8%). After using cash, the fund must sell about HK$40m of bonds. If the 10-year corporate bond and the perpetual are illiquid, the manager may have to sell liquid short-dated government bonds or accept fire-sale prices. Buying a 30-year bond with duration 12 would worsen the fund's sensitivity to further rate rises and add price volatility just when redemptions are rising.
The trustee should require a liquidity stress test, a redemption plan, and evidence that remaining investors are not disadvantaged. The manager should maintain a cash buffer, sell the most liquid holdings first, avoid the 30-year purchase, and consider whether redemption terms and liquidity risk disclosure remain adequate. The perpetual's call date and coupon reset should be modelled. Any use of side pockets or gates would need to comply with the fund's constitutive documents and SFC requirements.