Bond market liquidity has been a hot button topic of late. Concerns arise partly from market participants’ worries that regulatory and structural changes have reduced dealers’ market making abilities, but also from events such as the taper tantrum and the flash crash, during which U.S. Treasury prices fluctuated sharply amid seemingly little news. Even the Federal Reserve (the Fed) has analyzed changes in bond market liquidity amid signs that liquidity may be less resilient than in the past. Although many believe that liquidity and market volatility remain within acceptable ranges at this point, an extreme view is that as the Fed begins to take steps towards normalizing monetary policy, liquidity challenges will worsen and potentially trigger another financial crisis. While the issue of financial market liquidity continues to be highly debated, some concerned bond fund managers are defensively positioning their credit portfolios by holding higher cash balances or U.S. Treasuries. This paper will discuss what liquidity is and what has driven the great liquidity fright, explore if the liquidity situation represents a systemic risk and offer some recommendations for fixed income investors.
Liquidity Challenges Have Already Begun
Many investors are worried about a coming liquidity crisis without understanding what that means or realizing that they have already begun to experience higher liquidity costs and market price volatility. Although liquidity is a challenging concept to define, a basic definition is an investors’ ability to buy or sell a security at a known price, in reasonable size and within an appropriate time frame. This definition encompasses two factors used when assessing market liquidity: market breadth and market depth. Breadth relates to the overall cost of an executed transaction. It can be captured by the bid-offer spread, which is considered the price of liquidity. With the introduction of capital regulation, which will be further addressed below, it has become more costly to transact in certain markets. Spread widening, or increases in liquidity costs, has been witnessed in some areas of the bond market, particularly further out on the risk spectrum in the high yield, bank loan and emerging market sectors. However, higher liquidity costs do not equate to illiquidity- which has been an extremely uncommon happening in the United States. According to most market participants, buyers and sellers are still able to transact, albeit at a higher price. While wider spreads are not ideal, they do not necessarily imply a liquidity crisis. It is important to make a distinction here between the corporate bond market and the U.S. Treasury market. While the liquidity in both markets is being debated, bid/ask spreads in the Treasury market, which have been relatively narrow and stable since the financial crisis, suggest ample liquidity in that sector.
The more concerning aspect of liquidity is the potential lack of depth in the market. Trading volume relative to the size of the overall market (or trading turnover) has significantly declined in both the corporate bond market and the U.S. Treasury market. Many investors believe higher trading costs are a large part of the reason that corporate trading volumes have fallen. Furthermore, with respect to the Treasury market, although its size has grown since the financial crisis, much of the issuance has been absorbed by the Fed’s quantitative easing (QE) program. The average trade size per transaction has also fallen substantially in both the corporate and Treasury bond markets. The infrequency of block-sized trades is especially concerning because of the large average position size held by a number of the largest investment grade and high yield ETFs. Given the lessened role of the primary dealer community, and the fact that trade sizes are smaller, the concern is that, should rates rise and investors aggressively sell their fixed income holdings, the ability of investors to transact block-sized trades will likely be diminished, thus fueling further market volatility.
Regulatory and Structural Drivers of Liquidity Issues
Banks will no longer be able to act as shock absorbers
As opposed to equities, where standardized instruments are traded on an exchange, the fixed income universe is comprised of highly diverse securities. The role of the dealer is to make a market for securities, or buy and sell securities for their own account and make a profit on both sides of the trade. Post financial crisis regulations, such as the Dodd-Frank Act, which have required dealers to reduce leverage and increase capital, have made it more expensive and more difficult for larger dealer banks to hold sizeable bond inventories on their balance sheets and act as market makers. Should current bullish sentiments turn, and investors collectively wish to redeem, there may be no middleman bidding for these bonds, resulting in price dislocation and a liquidity crunch. Investors have already experienced higher liquidity costs and volatility. Regulation has reduced the ability to buy and sell bonds without affecting the asset’s price. By reducing the number of players bidding and offering securities on a daily basis, periods of heightened volatility have become more pronounced from a mark- to- market standpoint.
Surge in bond volume and greater retail ownership
The bond market has grown substantially since the financial crisis. Corporate issuance has doubled since December 2007 due in large part to low interest rates and high demand. Moreover, retail investors, through mutual funds and ETFs, have leaned towards the supposed safety of fixed income (total U.S. bond fund assets have grown to over $3.5 trillion, up from approximately $1 trillion five years ago). Of concern is that retail investors, historically, have been quicker to sell, such as in the spring and summer of 2013, when these investors rushed to redeem their investment grade bond funds amid the taper tantrum. Furthermore, fixed income funds have purchased increasingly riskier bonds in a search for yield, while still offering investors the opportunity to withdraw their money on demand. The Federal Reserve is moving towards its first rate increase since 2006. If losses associated with rising interest rates scare mutual fund investors enough to pull out, asset managers could be forced to sell bonds to pay investors back via a fire-sale type situation. This would push down prices quickly and exacerbate swings in a market that is already less liquid and crowded, as herding among big investors (those scrambling for returns in a low interest rate environment) is prevalent.
Is Liquidity a Systemic Danger?
While there is agreement amongst the investment community that liquidity in some sectors of the bond market is challenged, there is a lack of consensus regarding both the magnitude of the liquidity shortfall and the potential for systemic consequences if and when the Fed begins to raise rates. There is a view that the liquidity picture will continue to deteriorate, and a rise in rates will be the potential trigger for the next financial crisis. That being said, bond fund managers such as PIMCO and Eaton Vance note there is liquidity in the marketplace, i.e. there are buyers and sellers who are able to transact. It is the cost of that liquidity that has risen. According to many bond managers, while trading costs have certainly increased and spikes in volatility have become more commonplace, this does not pose a systemic risk to financial markets. Douglas Hodge of PIMCO writes that liquidity risk, or fluctuating asset prices in response to market conditions, is an ‘inherent risk of investing in capital markets’ and not to be confused with systemic risk. Prices may have to decline more significantly for a market to be made, but that is not the same as the system failing.
The fear continues to be that rising interest rates could be a catalyst for a broad shift out of fixed income funds. This, combined with the current higher liquidity costs, could result in meaningful price drops in traditional fixed income markets. These concerns are overblown, say some industry players. For one, investors purchase bonds as buy-and-hold investments for diversification and income; they do not buy bonds to speculate on short term interest rates. Thus, the thesis that everyone will liquidate when rates rise may be excessive. Secondly, according to Eaton Vance, there have already been sell offs in four fixed income sectors since the financial crisis: floating rate loans, high yield, investment grade and municipals. Each of these markets went on to recover within a year, and investors such as total return buyers (as opposed to dealers) provided the liquidity needed to help prices rebound. Reuters noted in a recent article that while new post crisis regulations have hamstrung the ability of banks to act as market makers, other parties have stepped in to take their place. Banks such as Deutsche Bank believe the figures regarding declines in dealer inventories have been overstated. Indeed, during periods of market turmoil, dealers have often been the first to unload inventories, exacerbating liquidity crises as opposed to mitigating them. Concerns over trading volumes have also been debated, as some believe the reason behind the decrease is a change in market players from fast money, leveraged accounts to more stable buy-and-hold investors and passive index funds.
All of this being said, it is evident that liquidity in the fixed income markets has evaporated to some degree, and the increased presence of open-ended funds, which offer on-demand withdrawals to retail investors, could most certainly pose challenges given the decline in secondary trading volumes. Although these challenges may not equate to systemic risk, there are implications of a tighter liquidity environment for investors.
Suggestions for Bond Fun Investors
Reduced liquidity and increased volatility can provide an additional source of return if investors have an understanding of the market challenges and can select the right managers to navigate such an environment. As such, we recommend the following for bond fund investors:
Know what you own. It is becoming increasingly important for bond investors to consider just how liquid the underlying holdings in their bond funds are. Given the post crisis, low rate environment, many managers have reached for yield by investing in riskier, less liquid securities. These securities may be more difficult to sell during a risk off period compared to highly liquid, traditional fixed income investments.
Ensure that your manager has an investment process that can effectively manage liquidity risk. Given that fixed income funds may have to hold onto bonds for longer periods of time, it is important to select managers that have a solid research process which allows for a deep understanding of credits in the portfolio. Also worth consideration is how a manager reacts during periods of challenged liquidity. For example, they may stress test to ensure funds could meet redemptions during periods of large interest rate moves. Additionally, management teams may search for value and avoid overcrowded trades. Or, portfolios may maintain higher cash balances/defensive portfolios, enabling management to be more opportunistic as prices decline and be liquidity providers later at higher yields.
Consider a multi-sector strategy. Managers of such strategies are continually looking for relative value among different sectors. These managers should be better positioned to capitalize on sell offs in specific areas of the fixed income market or move into sectors where there is more liquidity if selling ramps up. Moreover, by investing in diversified strategies, investors can spread out their interest rate exposure and diversify their fixed income allocation away from single factor interest rate risk.
Finally, don’t panic! If the fundamentals have not changed, investors need not rush out of their fixed income funds during a volatile market pricing cycle. It is extremely difficult to time or predict market disruptions or periods of large net outflows in specific market segments. Bond funds, and the income they provide, still serve an important role in a diversified, long-term investment line up.