New rules aimed at reducing risk in the over-the-counter (OTC) derivatives market are likely to alter bond funds investment strategies, ratings agency Moody’s has predicted.

It’s new report states that rules requiring the use of a central clearing house as a middle man between the two sides in an OTC trade are likely to increase funds’ costs and make some hedging arrangements less effective.

Bond funds, which have made increasing use of derivatives such as futures in recent years, face higher costs as a result of the rules. These require them to post initial margin, a deposit demanded by the clearing house to protect against default. Moves to cheaper alternatives, meanwhile, risk leaving funds exposed or forcing them to hire extra staff to help manage risks, warned Moody’s.

“Initial margin requirements could lead to a drag on investment returns for many bond funds as initial margins will become standard practice across the market for both cleared and uncleared OTC derivatives,” said report author Soo Shin-Kobberstad, a vice president and senior analyst.

“To reduce the cost of using OTC derivatives, some funds may choose to use less costly replacements such as standardised OTC derivatives or exchange-traded bond futures instead of customised derivatives that are tailored to their specific needs. Whilst lowering costs, these shifts could lead to bond funds holding imperfect hedges or additional credit risks in their portfolios."

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