Liquidity crimped by efforts to avoid another financial crisis
Sept. 15, 2016
In bond markets around the world, liquidity has been a story of unprecedented central bank policies, which have contributed to a surge in credit. On one hand, the question of liquidity on a global scale has appeared to be more a matter of a glut of credit, as a number of central banks have continued with less orthodox quantitative easing (QE) and other monetary policy efforts. On the other hand, the bond market liquidity experience in the United States has been different: Although the U.S. also has seen growth in the size of debt markets, there have been pockets of illiquidity in the last several years that have made trading markets more challenging. While it’s difficult to pinpoint precisely why this has happened, it appears that the issues are — at least partially — rooted in regulatory and legislative reform efforts, intended to avoid another event like the global financial crisis of 2008–2009.
Against this backdrop, monetary easing programs have pushed interest rates globally to such low levels that an increasing number of sovereign rates have dipped into negative territory. Some central banks, such as the European Central Bank recently, have attempted additional stimulus by making large corporate bond purchases. The net result has been a surge in credit that at times has flooded markets worldwide.
While corporate debt issuance has risen in the U.S., periods of bond market illiquidity have occurred. One example was the 2013 “taper tantrum” when there was a rout on Treasurys at the suggestion of a reduction in Federal Reserve bond purchases. More recently, in December 2015, a single high-yield mutual fund that was unable to meet redemption requests on its distressed-debt securities sparked another liquidity event.
What do these events and the buildup of debt mean for fixed income investors? In our view, it could have ramifications for markets in the years ahead as governments and companies are faced with maturing bonds. At the same time, liquidity in the U.S. bond market can also have a marked impact on risk management and investing. Times of relative illiquidity can add complexity and costs to bond trading and change the way portfolio managers need to model and construct their portfolios. That’s why, in our opinion, it’s important to not only know how to manage these pockets of illiquidity, but also to understand what may be behind them, and assess whether other market participants may want to consider similar adjustments.
Behind the liquidity issue
We believe the lack of bond market liquidity has stemmed, in part, from changes in regulations, many of which were made directly in response to the global financial crisis. There has been debate about how much impact the new regulatory environment has had, or whether some market participants were pulling back on risk-taking as a result of conditions and the overall environment. Regardless of whether regulations were primarily responsible or not, the amount of U.S. fixed income securities held by primary dealers — often investment banks that have been the main subjects of much of the regulatory pressure — fell sharply after the financial crisis. For example, Federal Reserve data suggest that dealer inventories of corporate bonds declined 75% from 2007 to 2014. From recent rules that limit proprietary trading by dealers to requirements that increase the amount of reserves banks must hold, these types of regulations have helped curtail the willingness of broker/dealers to warehouse securities.
From the Volcker Rule to Basel III
In 2010, the Dodd-Frank financial reform legislation passed and was signed into U.S. law, bringing with it what is known as the “Volcker Rule.” This restricted banks from making certain kinds of speculative investments, often referred to as proprietary trading. Another comprehensive and international regulatory effort has been the Basel III Accord. One of the important requirements of Basel III has to do with capital regulations, mandating that banks hold higher levels of reserves. This means that the dealer arms of banks are now less able to deploy capital to make markets in corporate bonds.
Regulators, at least in the U.S., don’t appear to be finished. For example, the U.S. Securities and Exchange Commission in 2015 proposed new rules to manage liquidity risk in open-ended mutual funds and exchange-traded funds (ETFs). The proposal would require more stringent risk management, including establishment of a liquidity risk management program. These rules are seen as likely adding further disclosure requirements and bureaucracy to the system, as well as additional costs.
A structural shift
Meanwhile, the credit market in the U.S. has exploded in size. New issuance has surged, spurred on by record low interest rates. As a result, trading volume has increased — but this is somewhat of a deceptive metric. The size of trades has declined and turnover has decreased.
Because broker/dealers are no longer deploying capital to the same degree, they aren’t in a position to serve as a potential “shock absorber.” This has created a structural shift in the markets. The result is that market participants will likely need to adapt to a set of new market realities.
Liquidity seems to be a factor in provoking some evolutionary changes in the way market participants invest. We believe that we’re at the beginning of that journey and the market is starting to exhibit signs of a changing landscape. One example can be found in the continued exploration of electronic trading platforms for bonds. While electronic trading platforms have not reached the kind of acceptance or widespread use with bonds as they have in the equity markets, the traditional method of over-the-counter (OTC) bond transactions may be used less and less in the future.
Because liquidity is likely to persist as an issue in the U.S. bond market — and could rise in importance as new regulations are introduced — market participants face certain adjustments. One factor we view as important is the size of an investment firm. It is critical for a firm to be big enough to be recognized as an important trading partner for its counterparties, but not so large that the firm has to rely on large macro bets to generate alpha, rather than focus on security selection at the core of its efforts to try to achieve return.
Another key factor is risk management. Portfolio managers need to be adaptable, adjusting their risk management practices to address a changing liquidity landscape. Importantly, we should try to construct portfolios with what we call sustainable risk. A portfolio manager assuming sustainable risk can have the opportunity to take advantage of stress-induced liquidity events, rather than suffer from them.
However, this may entail adjusting portfolios. For example, a portfolio manager who usually carries cash positions of about 1% might increase that allocation. It also might mean holding more agency bonds or Treasury-issued securities, which could be converted to cash more readily.
Moves like this could, of course, have a marginal impact on the portfolio’s yield, but we believe they are necessary as regulators implement requirements that drive change. Factoring in liquidity can be important for investors not only to try to protect to the downside, but also to attempt to incorporate any potential opportunities on the upside.
The views expressed represent the Manager's assessment of the market environment as of September 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. Fixed income securities and bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Funds may be prepaid prior to maturity, potentially forcing the Funds to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
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