Fixed income market liquidity, defined as the ability to transact in the market without affecting the asset's price, has always been varied. U.S. Treasuries, for example, which typically can easily be sold in volume at tight bid-ask spreads, are often cited as some of the most liquid securities in the world. Other fixed income assets, such as bank loans, sometimes only trade by appointment and often take weeks to settle. This disparity in liquidity presents both opportunities and challenges for investors. The global financial crisis has changed the nature of bond market liquidity and the most widely cited reason has been shrinking dealer balance sheets. Potential challenges stemming from bond liquidity have risen as evaporating market liquidity could cause prices to fall rapidly and sharply in the event of a market correction. The balance of this paper will explore current liquidity conditions across fixed income markets and the potential implications for investors' portfolios.
Unlike equity markets, where most trading takes place on an exchange, nearly all fixed income market trading is done "over-the-counter" (OTC). For many years, banks were the primary providers of secondary market liquidity in bond markets. However, following the global financial crisis, banks have been less willing to hold corporate bonds on their balance sheets for a number of reasons. The primary catalyst for shrinking balance sheets was the introduction of new regulations (e.g. Dodd-Frank Act) aimed at curbing proprietary trading and reducing systemic risks in global financial markets. As a result, banks today typically act as agents as opposed to dealing from their own inventory. To highlight this point, in mid- 2007, primary dealers (e.g. large U.S. banks) held approximately $225 billion in corporate bonds on their balance sheets. Today, holdings of corporate bonds are merely $60 billion, representing a ≈75% decline from their peak in 2007 (see Figure 1). In recent years, a number of electronic fixed income trading platforms have been developed in an attempt to fill the gap left by banks, although the impact of these platforms has been minimal at best. Thus far, however, the market reaction to lower liquidity has been fairly muted. What's potentially more worrisome is how markets react when and if central banks begin to unwind the various forms of easing they have undertaken over the past six years since the global financial crisis.
Figure 1: Primary Dealer Positions of Corporate Bonds ($millions)
Given declining trading volumes and the fact that dealer balance sheets have shrunk in recent years, bond markets, particularly investment grade and high yield corporate bond markets, appear more prone to bouts of illiquidity. During these periods of illiquidity, prices tend to "gap" lower and spreads correspondingly widen. Lower trading volumes and lack of willingness of dealers to take bonds on their balance sheets typically force investors to take a significant haircut in price when attempting to sell less liquid bonds. Emerging market debt markets serve as a prime example of what can happen during a period of illiquidity. Following the Federal Reserve's comments about a potential slowing of asset purchases in the summer of 2013, investors fled EMD markets causing a significant increase in volatility and a steep drop in prices. The local currency emerging market debt index (J.P. Morgan GBI-EM) fell nearly 4% and the hard currency index (J.P. Morgan EMBI GD) fell 2.6% in the first trading day following the Federal Open Market Committee's statement on asset purchases. These declines were partially triggered by $2.8 billion in net outflows from emerging market debt mutual funds during the month of June 2013, the largest net outflows in a single month for the asset class since its inception.
Significant growth in products that offer investors daily or even intra-day liquidity, such as mutual funds and exchange traded funds (ETFs), has the potential to exacerbate these issues. High yield and bank loan mutual funds, two of the less liquid sectors of the fixed income market, had $427 billion in assets as of July 31, 2014, up nearly threefold since the global financial crisis (see Figure 2). With bank loans in particular, settlement times can range from 7 days to upwards of 3 weeks. As mutual funds offer daily liquidity, there is the potential that investors will submit redemption requests faster than the underlying bank loans can be sold. In this scenario, it is possible that the volatility in the "most liquid" bonds will increase as they often are the first sale to meet redemptions. It should be noted that many bank loan funds have attempted to mitigate this problem by holding a portion of their assets in cash and more liquid high yield bonds. Additionally, many bank loan mutual funds and ETFs have credit lines that allow them to borrow money to meet redemptions.
Figure 2: High Yield and Bank Loan Mutual Fund Total Assets ($millions)
While the potential catalysts for and timing of a sell-off in the fixed income market are unknown, we believe investors should carefully consider how to best prepare themselves for a potential market decline. As a starting point, investors should reexamine their fixed income exposures, particularly as they relate to credit market exposure. Investors should be comfortable with the redemption terms and conditions of the vehicles they are invested in and, where possible, consider separate accounts. Although it is already a common practice for many, investors may wish to set aside a portion of portfolios in cash or high-quality fixed income, such as Treasuries and U.S. governments/agencies, to meet short-term liquidity needs. This could potentially eliminate the need to sell assets at depressed prices during the next market correction.
For investors looking to add fixed income market exposures, we would suggest a measured approach to gaining exposure. Investors should expect more extended funding periods for new allocations to corporate bond mandates as it could take several months to put money to work depending on market conditions. Buying Treasuries up front is one way to neutralize duration risk during this process. Liquidity, or lack thereof, also impacts an active manager's ability to add value, given increased transaction costs and potential difficulties adjusting exposures in a timely manner. For managers with outsized positions in certain issues or seeking to establish large positions, declining liquidity can be particularly problematic. Expanding the opportunity set for active fixed income managers to include derivatives and other sources of liquidity could create additional sources of alpha for managers that have the appropriate skill set and experience.
While central bank stimulus has been credited with creating massive amounts of liquidity in global capital markets, other market and regulatory developments have actually reduced liquidity in certain bond markets for investors at the same time that investors' search for yield has increased their exposure to many of these markets. Market sell-offs are rarely orderly and the potential for a large amount of money to exit credit markets with no natural buyers could intensify a market decline. We would encourage investors to review their fixed income portfolios in terms of security types, maturities, and vehicles to be sure they are comfortable with their access to liquidity. Investors may also wish to allocate a portion of their portfolio to Treasuries or government securities to meet ongoing liquidity needs.