Investors more concerned about FI liquidity


By Wouter Klijn

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Institutional investors are increasingly concerned about the decreasing levels of liquidity in fixed income markets as global regulations and an increase in retail presence are changing markets.

“I don’t think we have one client conversation globally where [liquidity] doesn’t come up,” Western Asset Management deputy chief investment officer Michael Buchanan said in an interview with theinstoreport.

“It is really about the changing regime, the changing environment of trading fixed income securities. There is no denying that.

“The question is: ‘Are we getting compensated enough for that and what are the bigger risks that could transpire because of that?’”

Buchanan pointed to a particularly concerning liquidity problem in high-yield bond markets, where the advent of exchange-traded funds (ETF) had led to billions of dollars of retail money flowing into the sector.

“The bigger risk clearly is in high yield as it has a heavy retail concentration,” he said.

“About 30 per cent of the high-yield market is retail and a growing part of that are ETFs.

“Not only do you get daily liquidity like a mutual fund, but you also get liquidity throughout the day.

“The real question is: ‘If retail had a mass exodus from this asset class, what would happen?’

“Clearly, we don’t have a liquidity mechanism to absorb that supply.”

The two most popular high-yield ETFs are the BlackRock iShares iBoxx corporate bond, or HYG, and State Street’s SPDR Barclays Capital High Yield Bond ETF, or JNK.

Since the launch of these ETFs in 2007, the HYG ETF has amassed US$15.5 billion in assets, while the JNK holds US$11.4 billion.

In mid-2014, these ETFs recorded sharp outflows, losing more than US$4 billion over the five-week period to 8 August 2014, causing much debate about the impact of retail ownership of these bonds.

Although Buchanan argued the high retail presence in high-yield bond markets formed a tangible risk, he was relatively confident it would not come to a real liquidity crisis.

“The development of ETFs has brought in a new constituency into high yield that does really want that minute-by-minute liquidity,” he said.

“But historically it has been more resilient than you think.”
Markets coped with the outflows last year, but it is certainly a situation many fixed income managers monitor closely.

Western Asset Management has developed its own rating system, which measures the liquidity of each individual bond in its portfolios and gives these bonds a liquidity score.

“We track the liquidity of each individual bond in our portfolio and apply an overall liquidity score to our portfolios in relation to the benchmark,” Buchanan said.

“So our portfolio managers know at any given time what their liquidity profile is in relation to the overall market.”

The firm also noticed mandatory reporting frameworks, including the Trade Reporting and Compliance Engine, reduced liquidity in some of the smaller, less frequently traded corporate bonds.

“Seven years ago bonds didn’t need to be reported, so you were incentivised if you were a corporate bond trader to go out and give some liquidity to a bond that doesn’t trade that often, and if you were good at that, you might be able over time to exit that position and make a pretty good profit margin,” Buchanan said.

“Nowadays, as soon as you buy that everyone knows exactly what you paid for it and they are not willing to let you work for much, so most traders opt not to trade in those securities.

“So the less liquid bonds have become much more difficult to trade, but there is a benefit to that: we are getting paid a lot more to own those and we price that in as we look at new deals.”

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