By Roger Webb
There’s been a lot of mention of the phrase “liquidity crunch” in the media of late. (By liquidity, I mean the ease with which an investor can buy or sell bonds in the market place without moving its price).
It’s little wonder. Accessing liquidity is challenging at the moment in the corporate bond market and has been extreme since the global financial crisis. This situation is unlikely to change – that means the asset management community is having to adapt to the new investment landscape.
As a direct consequence of the crisis, banking regulators globally have sensibly introduced tougher capital requirements for the banks in their jurisdictions. These banks – which act as market makers for buyers and sellers of bonds – have been required to add to and improve the quality of their capital bases. In order to trade bonds the same banks have to put more of their own capital at risk. Naturally, this has reduced their desire to act as intermediaries, and the knock-on effect is that it is now much more difficult for investors to trade corporate debt.
The ultra-loose monetary policies pursued by the major central banks – the US Federal Reserve, the Bank of England and the European Central Bank – have had a number of effects. Some of these have resulted in a number of consequences for the corporate bond market. The fact that government bond yields are anchored at ultra-low levels – and indeed are veering into negative territory in sizeable pockets of Europe – has triggered a “hunt for yield”. This led to a big upsurge in demand for credit and a simultaneous tightening of risk premiums (spreads).
Activity is often focused on the primary market, with the secondary market inconsistent at best due to liquidity problems. Robust levels of new issuance are likely to continue in all the major currencies. New deals are often significantly oversubscribed, but offer investors a chance to add exposure to names they understand, and at prices which suit. Recently, the Bank for International Settlements pointed out that liquidity problems have grown because trading volumes have not kept pace with this surge in debt issuance. While this is true, it has probably had less of an impact than the shrinking bank balance sheet issue.
Greater demand for fixed income assets like corporate bonds, influenced by monetary policy action, presents us with the question – what happens when policy measures cease or reverse?
Clearly if everyone looked to exit the asset class together there would be some problems. A lack of depth in liquidity has always been apparent in corporate bond markets – as we saw from price action during the crisis. Such price moves could be severe, given the ever smaller balance sheets of our counterparties. Even a marginal seller could trigger some big moves as potential buyers step further back.
What does this mean for investors in bonds? In the current environment it doesn’t mean all that much, as the credit markets seem relatively attractive and benign. We do not think there is a “great rotation” out of bonds at the moment, but we do remain aware of the risks and we believe that we need to be paid a premium for illiquidity.
We also need to shape our businesses appropriately. It is harder to justify short-term high performance targets in large corporate bond funds where illiquidity could restrict the manager’s ability to re-position the fund. The majority of clients still, however, invest for the long term and can tolerate mark-to-market volatility. This has been illustrated by a growth in “buy and maintain” corporate bond mandates, where liquidity is less vital but management of credit risk is still paramount. We have also seen a gradual move from single-currency to multi-currency offerings and single bond asset class to multi-asset bonds, both of which broaden the pool of liquid assets.
Those who cannot invest with a long-term horizon should consider more dynamic approaches to bond allocations that would enable managers to manoeuvre when markets become more challenging. More flexible and diversified mandates which can use all the investment tools available will definitely provide investors with some comfort against the liquidity risks.
Roger Webb is a senior investment manager at Aberdeen Asset Management
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