Bond market liquidity evaporating for investors

19-Feb-2015

By James Brooks

Investors be warned! With liquidity rapidly evaporating, corporate bond markets will now lock up and lock out returns, according to Payden & Rygel managing principal Scott Weiner.

Speaking at the PortfolioConstruction Forum’s Markets Summit in Sydney on Tuesday, Weiner did not mince his words when talking about the dire situation facing today’s secondary corporate bond markets.

“In the year 2015, liquidity stinks in the bond market. The problem is structural and it’s here to stay,” he said.

“The secondary corporate bond market is in a time of significant upheaval.

“While volatility remains low, bid-ask spreads appear tight and debt issuance is at all-time highs, underlying changes to the role of broker dealers due to regulations meant to support the banks has caused a new, insidious liquidity risk.

“With the bond market still fragmented and traders more heavily reliant on derivatives and ETFs (exchange traded funds) to simulate holding actual bonds, two-sided bond trading has become more difficult as banks no longer are willing to take the other side of a transaction,” he said.

Citing Westpac corporate bonds as an example, Weiner noted that today, even trading $5 million in bonds can prove to be difficult.

“Westpac bonds will have liquid days for about 60 per cent of the time and less liquid days for about 40 per cent of the time.

“On the liquid days, you can find about three or four dealers that will be prepared to take $5 million of Westpac’s 3-year bonds and, if you’re lucky, you may find someone who’d take a block of $10 million.

“Contrast this to back in the ‘80s when sizes of $50-to-$100 million were being traded in big name corporate bonds, and you see that liquidity has dried up.

“But it gets even worse – during 40 per cent of the time, when liquidity is less, you’ll be lucky to find a dealer who’d buy even $1 or $2 million of these 3-year Westpac bonds,” he said.

Herding

In simple terms, liquidity refers to the ability for buyers and sellers to transact quickly, in volume, with minimal price impact and little price differential between the two sides of the market.

However, when liquidity evaporates, as is occurring in today’s markets, the broader implications are very serious for investors, according to Weiner.

“This troubling lack of liquidity has resulted in greater herding behaviour in the market that is being exacerbated by cheap money from central banks and incredibly tight spreads.

“Now, the bulk of bond investors seem hesitant to act as uncertainty about Fed policy, geopolitical risk, and tight spreads are creating worries about a bond sell-off and, should a sell-off begin, a lack of liquidity, when it is most needed, could cause a fire sale,” he said.

As such, Weiner strongly recommended that fund managers be wide awake to these issues so as to adequately manage their clients’ expectations given that this lack of liquidity will result in increased volatility in the future.

With dealer balance sheets increasingly constrained, he said managed fund holders must now recognise that funds may limit withdrawals and hold larger cash balances.

Furthermore, high turnover ratios, fund sector allocation and other shareholders’ selling decisions will characterise today’s fixed income market landscape and erode returns.

“Trying to time the turn will be next to impossible, but by having a diverse array of flexible strategies to minimise selling holdings during and after a sharp price drop and have the funds to pay redemptions and acquire debt at fire sale prices, it should be possible to weather the storm,” Weiner said.

New Neutral

Taking a more macro-level perspective on the current travails of the bond market, fellow summit presenter and head of portfolio management for PIMCO Australia, Rob Mead, said the role of bonds still remains important in any multi-asset portfolio.

“The role of bonds is still key, but you need to be diversified in your allocation and not put all your eggs in one basket,” Mead said.

“We’ve applied our secular ‘New Neutral’ hypothesis, in which average policy rates are set much below the levels that prevailed before the global financial crisis and will remain there for a much longer period of time,” he said.

In terms of allocation themes in rates and credit, given the likelihood of the Federal Reserve hiking interest rates later in 2015, PIMCO favoured fixed income sectors that were less sensitive to rising rates, such as European peripheral debt, US non-agency mortgage-based securities and select emerging market debt sectors.

Reflecting this New Neutral shift, PIMCO is now overweight global equities and underweight in global rates over the cyclical horizon relative to what a well-diversified portfolio would normally have.

“Tactically, we are slightly underweight interest rates. We think illiquidity is very contained in terms of certain sectors of the bond market, as part of it are extremely liquid given that there’s lots of central bank activity buying up supply,” Mead said.

“Cyclically, we think interest rates look moderately low and we consider their potential to rise to be only very modest.

“People will be very pleased to hear a bond manager recommending being overweight in equities, but they should be clear on our reasoning that the structural nature of interest rates and the anchor they provide is permanent, and as such they should be thinking about this on a permanent basis.

“There’s also an important caveat to this: we’ve made these forecasts in January and since then equities are already up 9 per cent, so they’ve already done what we expected for the whole year,” Mead said.

In the equities space, PIMCO favours European and Japanese stocks on a currency hedged basis, while also finding attractive investment opportunities in emerging Asia.

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