Bond markets, the liquidity dilemma

Impacts of regulation & quantitative easing: How do you assess the liquidity situation of major bond markets? Which parts of the global fixed-income universe are currently depicting the strongest declines in liquidity and to what extent could those shortages potentially pose a threat to other market segments?

Before answering above questions we need to define and make the distinction between liquidity levels and liquidity risks.
Liquidity levels are measured by the size of sectors within global bond markets as well as by the ability of the banking system to provide market timely bid and offer prices to investors. Since the Great Financial Crisis in 2008 we have witnessed continuous growth in government and credit markets. Governments increased issuance in order to bail out the financial system and support growth, companies tapped public capital markets as banks were reducing balance sheet size. The latter had to comply as well with harsher regulation (Dodd Frank, Basel III) that led to reduced inventories in their market making function. Higher capital requirements towards trading books has consolidated market making activities into the hands of fewer global investment banks. Thus, liquidity provisioning has become more concentrated but not cornered. But, has the advent of quantitative easing programs by a long list of central banks not reduced availability and created scarcity that might become alarming? No. That the BoJ holds around 36% of all outstanding JGB’s or the ECB at this juncture holding about 15% of EGB’s might have caused extreme richness in valuations, liquidity levels are still abundant.
Liquidity is protected by constraints on issue level holdings. On top we expect the DM governments will kick-start fiscal stimulus programs thereby increasing supply of bonds. Overall, we can state that liquidity levels in government bond markets remain healthy and intact. The presence of central banks in IG credit markets might cause more concern. Central banks should refrain from being present for too long. Credit market liquidity is provided by over the counter market making. If central banks create scarcity in these growing credit markets they might impact their long term health. At this stage high yield markets are not in scope. Our base case scenario does not foresee that central banks start purchasing high yield bonds but rather resort straight towards equity ETF’s as is the case in Japan.
Liquidity risk embodies the price impact or cost for an order of a given size traded within a given time horizon. The majority of bond mutual funds and ETF’s provide net asset values (NAV’s) on daily basis and investor can monetise their investment any day. Acceleration of redemptions might give rise to acute liquidity risk faced by the bond manager. Continuous assessment of fund liquidity risks comes at the same level as control for interest rate, credit and FX risks. Fact is that the share of mutual funds in overall bond holdings has risen above USD 7 trillion for a global bond market sized around USD 95 trillion. Even if the market of bond mutual funds more than doubled over past 10 years, the global bond market kept pace! So we should focus on liquidity risk at the specific bond fund level. We advise that investors request transparency on the following items:

• Information on liquidation horizon or how long does it take to sell x% percent (and by value) of the fund over how many days/weeks/months.
• Presence of liquidity measures, scores within risk control framework under normal and stressed conditions.
• Calibration of investment size per line; fund manager need to assess how efficiently high conviction investments can be sold.
• Check presence of experienced buy side dealing desk that monitors and has good relationships with sell-side liquidity providers.
• Presence of derivatives that require certain collateral; to what extent is the collateral liquid ? Our preference goes towards cash collateralization instead of through ‘liquid’ securities.
• Presence of market best practice swing pricing process that protects shareholders but also refrain them from panicking.

The last point of attention concerns the resilience or recovery speed of market liquidity when shocks occurred in financial markets. From experience we notice that OTC bond markets across sectors (Government, IG credit and High Yield) show high levels of resistance although temporary black outs do occur. We repeat the importance of:

• diversification across fixed income sectors as well as within sectors
• knowledge on liquidity needs (Know your Customer: prefer investors, fund shareholders with long term investment horizons) and,
• presence of high shares of liquid investments across the maturity buckets.

As a conclusion we are less worried on liquidity levels and liquidity risks as markets can and will adapt towards higher levels of regulation. Regulators should also be able to adapt capital and risk control requirements whenever these become too constraining for the well-functioning of capital markets. Common sense should prevail. Bond managers and investors should be aligned in terms of investment horizon. In the end a bond managers should be prepared at all times to tackle market shocks and redemptions and not resort to gating or applying steep dilution discounts in order to protect shareholders.

Peter De Coensel – CIO Fixed Income – Degroof Petercam AM