Bond fund managers are learning to live without predictable liquidity in secondary markets.
The problem is not new: last summer, AsianInvestor highlighted the growing concerns about regulation and risk-based capital rules’ impact on banks’ broker-dealers. Increased costs of capital have prompted banks to pare back inventory as well as shutter proprietary trading desks.
Lately, concerns about secondary markets have risen alongside the likelihood of the US Federal Reserve increasing interest rates for the first time since 2006.
“When many investors have been short duration, that money will leave the front end of the yield curve,” said Henry Peabody, a fixed income portfolio manager at Eaton Vance Investment Managers in Boston. “That money will need a home; there needs to be a bid for that money. But Wall Street is no longer bidding.”
Investors fear that any surprise or miscue as rates begin to increase could spark a market reaction that, given the lack of global secondary market makers, could spiral out of control.
The 2013 ‘taper tantrum’, when then-Fed chairman Ben Bernanke first mooted the idea that the Fed’s quantitative easing programme of asset purchases might one day stop, is seen as evidence of skittishness. What happens when the Fed goes from musing about raising interest rates to actually pulling the trigger?
Although bond fund managers know they’ll have to ride out bouts of volatility, the decline of broker-dealer activity may prove more of an annoyance than a crisis, so long as they aren’t forced to sell.
“There’s a fear of smaller balance sheets on the Street – not that Wall Street ever came to the rescue anyway,” said Andrew Hofer, managing director at Brown Brothers Harriman in New York.
The real problem, he said, is QE: “The market has gotten used to having the Fed be an indiscriminate buyer. For six years, people have bought Treasuries assuming they could always sell them at a higher price. Investors traded Treasuries like stocks. Now they’ve grown worried about volatility.”
Steve Meier, CIO for global fixed income, currency and commodities at State Street Global Advisors in Boston, said liquidity fears are overblown. “The market functions,” he said. “Bid/ask spreads lack depth and you may not be able to sell assets in size, quickly. You don’t want to be a forced seller.”
But the actual mechanics in the secondary market remain intact, Meier said, noting that there remain specialist dealers not tied to banks that continue to make markets in fixed income.
Like many investors, he assumes there will be spikes in volatility. “There’s a new generation of portfolio managers, credit analysts and traders in the market who have never seen a hike in interest rates,” he said. “No one would be surprised if there is an overreaction,” particularly as the crowded trade into Treasuries and high-grade corporate bonds unwinds quickly.
William Adams, CIO for global fixed income at MFS Investment Management in Boston, said liquidity has become a more prominent risk, but is not a new one.
“Valuations in periods of stress find themselves. Only now that process will be swifter, and new buyers will step in – such as private equity or asset owners. It won’t be banks.”
Mutual funds and bond exchange-traded funds are likely to suffer the worst liquidity crunches, because they offer daily or instant liquidity. Some managers warn that mutual funds may be forced to gate redemption requests.
Those money managers able to act with discretion, and who maintain higher cash levels or other forms of dry powder, will stand to benefit.
“The question is, who has the balance sheet now?” said Peabody at Eaton Vance. “What’s the liquidity risk premium? Banks became market makers in the 1990s and 2000s. Now they are restricted and don’t carry inventory. At some point, asset owners will reallocate to take advantage of the liquidity premium in bonds.”
In other words, it is the buy side, acting on behalf of sovereign wealth funds, pension funds and other clients, who will become the new bidders, but only after volatility has squeezed those who are forced to sell.
“Clients need a longer time horizon,” Meier said, “and to recognise that a market event won’t last for long.”