Liquidity in Asia’s dollar-denominated bonds has become a rising risk factor, due to a cocktail of the global hunt for yield, tougher bank capital rules and a drop in issuance, say investors, who are discussing ways this might be resolved.
Ashley Perrott, head of fixed income for pan-Asia at UBS Asset Management, said liquidity had become a key risk concern in the mind of investors. He was speaking at a webinar organised by AsianInvestor and data provider Markit.
“When you ask real-money asset managers [about investing difficulties], liquidity is always at the forefront of their minds,” he said, adding that the trading environment had changed from what it was 10 years ago and was unlikely to revert to its previous state.
He pointed to the introduction of Basel III bank capital rules in particular as a factor behind this. Banks were traditionally large market-makers in the bond market, holding sizeable inventories of bonds.
But under Basel III rules on risk-weighted assets, banks have to hold more capital against every bond they keep on their balance sheets. That has made this inventory model very capital-intensive, and meant most banks have scaled back their bond inventories.
Aleksey Mironenko, director of iShares Specialists for Asia ex-Japan at BlackRock, noted that broker-dealer inventories in the US had dropped sixfold between 2007 and today, from a total of $250 billion to $40 billion. “And there’s no question it’s happening here too,” he added. “As a result, you need to do more work to find the bonds you want.”
Perrott noted: “Not all banks want to compete in all parts of the market, so it’s important to have strong relationships with different counterparties.”
Unfortunately, there doesn’t appear to be any way to improve liquidity any time soon. Large amounts of international investor money will remain keen to invest into and hold Asia’s relatively higher-yielding dollar bonds, while there does not appear to be any institution ready to step into the shoes of banks as a broad market-maker.
Perrott even has his doubts about the ability of technology to find a solution. “Potentially there are different platforms trying to gain ground and provide a platform for investors and brokers,” he noted, pointing to efforts by Singapore Exchange, Tradeweb and MarketAxess to offer electronic bond trading venues.
“How successful can they be when there are four or five platforms rather than just one?” he rhetorically asked. “From my perspective it would be better if there was just one source. Hopefully there will be a solution from the tech side.”
Arthur Lau, co-head of emerging markets fixed income at Pinebridge Asset Management, agreed with Perrott that the capital cost of holding bond inventory was forcing market-makers to become niche players. However, he argued, perceptions of a deterioration in liquidity were “a bit of an illusion”. He noted that the size of the Asian dollar bond market had grown from about $100 billion in 2009 to $640 billion this year.
But Mironenko said the growth in outstanding dollar bonds in Asia ex-Japan hadn’t solved liquidity issues.
“The market has grown, but demand has grown even faster,” he noted. “Ten years ago 100% of fixed income markets yielded over 4%, but today you only have emerging markets and US high yield doing so. The bid for yield has pushed an immense amount of demand towards Asia at a time when supply has decreased about 15% year-on-year between 2014 and 2015.”
Mironenko touted fixed-income exchange-traded funds as an alternative means of offering liquidity, arguing that their high daily trading levels help offer bond exposure while also providing liquidity. However, buying what is effectively an equity instrument is a problem for many fixed-income investors, which have prospectuses that forbid them from buying such assets.
Impact on indices
Tight bond liquidity also has an impact on index providers. “You can’t create a perfect benchmark that is both very representative and has high liquidity,” said Randolph Tantzscher, director of indices for Asia-Pacific at Markit.
Lower market liquidity affects benchmarks in various ways, he added. “A lack of dealer inventory means there is less observable data about where instruments trade, so there is less information available to value illiquid securities,” he said. That means less certainty that such bonds are being accurately priced and probably wider bid-offer spreads.
AsianInvestor asked the audience listening to the webinar what were the most important factors affecting liquidity in Asia’s bond markets, offering four options. The most popular response, with 37.1%, was US interest rate expectations, but 32.6% voted for an overabundance of liquidity in dollar bond markets, and 30.3% pointed to China’s economic policy as the biggest influence.
“Those are quite evenly distributed factors,” noted Lau, adding that he felt US rate expectations were driving most key factors behind liquidity.
Mironenko added that the importance of each could often change on a daily basis, while Perrott said liquidity could also depend on the size of orders. “If you hold $30 million to $40 million of a particular bond, then interest rate expectations and what happens with China is very important.”
To listen to the full webcast on demand, click here.