The withdrawal of investment banks as secondary fixed income market-makers combined with thin bond trading has stoked fears of a market seizure in the event of a credit or rate shock.
As a result of regulatory changes designed to make banks safer, the broker-dealer arms of the major financial institutions have been forced to increase reserves, reduce risk and get out of a variety of trading activities.
The result: markedly reduced inventories of fixed-income securities. “The liquidity structure of the market has been changed forever,” said Steven Meier, CIO for global fixed income, currency and cash at State Street Global Advisors in Boston.
According to banking lobby the Institute of International Finance, leading dealer inventories in the US are 25% of what they were in 2008, and turnover is less than half. The downturn is acute in corporate bonds but also affects Treasuries and asset-backed securities.
Outside of the US, emerging-market bonds have seen trading volumes plummet, especially for corporate bonds, even as primary issuance has soared.
“It’s become two markets for dealer drawdowns,” said Michael Materasso, co-chair of the fixed-income policy committee at Franklin Templeton in New York. “Liquidity in the primary market of new issuance is great. But it’s thin for the secondary market.”
What it means is that investors, hungry for yields, have piled into securities that lack a reliable secondary market at a time when the US Federal Reserve is poised to end its quantitative easing programme, with a rise in interest rates likely to follow next year.
Although the Fed has been adept at preparing markets for this shift, such transitions are rarely smooth – and therefore a thin secondary market could worsen volatility.
This summer’s high-yield sell-off gave the markets a taste of what this could be like. “That was a shot across the bow,” said Jeffrey Knight, global head of investment solutions at Columbia Management in Boston.
This July retail investors in high-yield bond ETFs redeemed and spreads widened by 90 basis points in days. The tempest was short-lived, as many institutional buyers decided this made high-yield attractive and piled in.
Nothing about the fundamentals or the credit quality had changed, and many investors such as Knight remain overweight the asset class. But the event showed how illiquid markets can switch from placid to volatile in a short time, and the impact that even marginal buyers can have in such conditions.
The tail-risk (that is, unlikely but potentially very damaging) is a wider, deeper sell-off. US monetary policy is diverging from the still-easing stance of other major central banks, giving rise to missteps and unpredictable market reactions.
On the one hand, the high-yield episode suggests that parts of the bond universe are going to experience bouts of volatility, particularly where there is a mismatch between ETFs or retail mutual funds with daily liquidity requirements and less liquid markets, including emerging-market debt, leveraged loans and corporate bonds.
This might lead to little more than short-term pain for anyone keen to exit, as prices move against them, and the need for other investors to extend their time-horizons and ride out the turmoil (and if they have cash to deploy, take advantage once the dust settles).
But the high-yield case could also breed complacency, on the assumption that there won’t be a major liquidity event because there’s such high demand for bonds, particularly for US dollar assets.
“Mutual funds and other institutional buyers stepped up when retail investors sold high-yield ETFs,” said Andrew Hofer, managing director at Brown Brothers Harriman in New York. “But what if those buyers aren’t there?”
Fortunately there continues to be huge demand for US Treasuries and corporate bonds, which should smooth bouts of volatility.
Pension funds and insurance companies in the US and Europe are in many cases de-risking portfolios and buying bonds; Chinese and other Asian central banks remain avid buyers for their foreign reserves; corporate balance sheets remain solid and there are no signs of any rise in default rates; and the negative returns on European and Japanese government bonds (often in absolute as well as inflation-adjusted terms) support demand for US assets.
But when secondary markets are so thin, it’s conceivable that a relatively marginal buyer can cause outsized problems, particularly anywhere outside of US sovereign debt.
After all, non-agency subprime mortgages were just 11% of US credit markets in 2007, but when investors began to pull out, it caused a run that ultimately destroyed Bear Stearns and Lehman Brothers.
The odds of another event like that are low today. Those failed institutions were highly leveraged; markets today are not. Regulation pushing broker-dealers away from holding inventory has also increased transparency.
A broad desire among institutional investors for yield makes Treasury markets relatively attractive within fixed income. Any rise in US interest rates will be limited by modest economic growth, while the European Central Bank and the Bank of Japan are ramping up their quantitative easing programmes; even the People’s Bank of China is injecting capital into its banking system.
Nonetheless, investors are looking at ways to make sure they get through the inevitable bumps they may encounter due to the lack of dealers taking the other side of a trade.
These include extending investment horizons; increasing cash; paying attention to the retail market and considering how to move money in the event of a surprise; and upgrading trading capabilities.
Certainly there have been market innovations to deal with the decline of broker-dealer inventories, namely in the form of electronic platforms among buy-sides that cut out the intermediary.
But managers say these initiatives are not attracting big flows. There is also scepticism that an all-buy side platform would help in a time of crisis, as the big fund houses tend to move in herds; there wouldn’t be a natural buyer among them.
And if conditions became seriously dangerous, asset managers in the US, at least, might be able to turn to the Fed for help. Just as investment banks adjusted their legal structure to declare themselves commercial banks during the 2008 crisis in order to receive lines of credit, it is feasible that big fund houses could do something similar.
So the likelihood of illiquid secondary markets creating a true disaster in fixed income is remote – but the odds of it generating temporary seizures in specific sectors around the world are high, and increasingly in line with investor expectations of a rise in US interest rates.