Investment committee: How liquid are bond markets?

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LauraSuter

Laura Suter is editor of FundStrategy

Bond liquidity is top of many investors’ minds as fears about the market reaction to any interest rate rise have sparked concerns about a drying up of liquidity in bonds.

Increased regulation has meant there are fewer participants in the bond market, and has led to banks holding lower inventories, particularly in the corporate bond space. The fears around liquidity in the market even prompted the Bank of England to publish a blog post on the topic, warning that the bond market may have been destabilised by this regulation.

While there are few immediate worries on liquidity, the concern is that when the Federal Reserve does eventually raise interest rates in the US it will lead to a rush for the exit, sparking liquidity problems.

In light of this, concerns have already been raised about the largest bond funds and their ability to liquidate assets in time to meet any rush to the exit. Fund selectors warn that they are hunting for smaller, more nimble bond funds and are asking managers hard questions about liquidation times.

But bond fund managers are caught in a Catch 22. The ‘safest’, most liquid assets are those returning virtually nothing, harming fund returns. The case is the same for any substantial cash holdings being retained to boost fund liquidity.

Some managers wanting to meet return targets are moving up the risk spectrum into high-yield debt and other vehicles that are likely to be hit hardest by any liquidity dry-ups.

Currently, Man GLG Strategic Bond fund’s Jon Mawby thinks any liquidity problems are being masked by the ongoing inflows into the bond space. But when this turns around and net outflows begin, the tide is likely to go out and leave many bond fund managers exposed.

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Tim Cockerill is investment director at Rowan Dartington

Liquidity has become the buzzword recently and not just in relation to bonds but with markets in general. There’s no doubt it is a risk that is increasingly being considered by investors.

It’s quite commonplace now for fund managers to quantify how long their portfolio would take to liquidate. But I can’t help feeling this is a pointless exercise, firstly because they’ll never do it and secondly because the conditions giving rise to this type of situation would be very different to those at present, as would liquidity conditions.

For me this is the issue – liquidity in bond markets has reduced in recent years as the increased regulatory requirement for capital has changed the nature of bond markets and trading in them, leading to the exit of many bond traders. For now while markets are calm, liquidity seems to be quite manageable but the indication from managers is that this could change quickly. If this is a concern then fixed interest holdings should be skewed towards those that are most liquid and in the UK that would be the gilt market.

But this creates a dilemma as the outlook for fixed interest is poor because of the widely held belief that interest rates are going to rise – the downside over the next two or three years is far greater than the upside. Gilts look expensive and of course one reason for this is their liquidity profile, so it’s a case of ‘you can’t have your cake (higher yield) and eat it (liquidity)’. The risk of a liquidity crisis is hard to judge but it’s likely to be predicated on rising interest rates and right now that risk isn’t high, in fact it seems to be reducing.

If, however, there was a crisis then bond prices will fall sharply, spreads will widen and screen prices won’t be indicative of what you’ll get when you eventually find a buyer. The flip side is that yields will spike and there’ll be bargains for those willing to take the risks.

Diversification between asset classes should always be part of a portfolio but in times of acute stress correlations come together and diversification breaks down to a greater or lesser extent. There are potential alternatives to fixed interest, such as commercial property, but this is less liquid still and if we see a repeat of 2007/08 then funds shut their doors, although property funds today typically run 20 per cent cash for just such illiquid times.

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Lee Robertson is chief executive of Investment Quorum

One of the most talked about subjects over the past 12 to 18 months has been concerns surrounding bond market liquidity, and while investors should be mindful on the issue of liquidity, the eye of the liquidity storm was probably back in 2008 in the midst of the financial crisis.

Since those bleak days, the FCA has requested that all of the very large bond funds stress test their portfolios in the event of a ‘bond crisis’ or ‘bond tantrum’. In fact, both ex-Fed chair Ben Bernanke and current chair Janet Yellen have both sparked concerns in the bond markets over the past 12 months when talking about monetary tightening  but bond prices have recovered fairly quickly after both events.

Unquestionably, when interest rates do begin to rise then long-bonds are at a greater risk, alongside high-yield bonds, therefore investors should be wary of capital erosion as prices fall and yields rise.

But of course, with central banks around the world remaining very supportive of the current global economic slowdown interest rates are only likely to rise slowly in the US and UK, while in Europe and Japan further QE will suppress yields further as the ECB and BoJ continue to purchase sovereign bonds.

Given that the new norm for interest rates is probably going to be much lower than in previous times, investors are likely to remain engaged in this asset class, using it as a safe haven when volatility rises in the equity markets. Admittedly, bonds do look expensive against equities, based on valuations, but yields on 10-year government paper still looks more attractive than cash even when taking into account inflation which remains stubbornly low.

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John Husselbee is head of multi asset at Liontrust Asset Management

As a result of extraordinary monetary policy since the global financial crisis, mainly in the form of money printing on a global scale, there is certainly an excess of liquidity in the markets today. How this will all be unwound by bank authorities and regulators remains one of the biggest known unknowns in financial markets.

Money printing has driven government bond yields to historic lows and asset prices to historic highs. The hunt for yield has been, and remains, a major challenge to investors wanting to maintain the appropriate balance of risk and reward.

We have looked to alternative strategies to assist, both in bonds and also with equities.

Strategic bond funds, the so-called jugglers of bonds, have grown rapidly in their popularity and size. This is not surprising when these strategies are offering the potential to hedge both credit and duration risk. A number of these funds are far too large for any part of the investment cycle, and we as investors, rather than speculators, prefer the smaller funds where there is at least more flexibility.

With the regulatory environment tightening, there are the obvious fears of a short-term liquidity crisis, but long-term investors can accept shorter term volatility on the way to achieving a long-term objective.

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James Calder is head of research at City Asset Management

Predicting rate rises has been a mugs game over the past three years, however, the start of the next cycle does appear to be around the corner, particularly in the US. Economic conditions have improved to the point where the decision not to raise rates would leave the market aghast.

The Fed is under pressure to raise rates soon, owing to the fact that, inconveniently, 2016 is an election year and they will be loathe to be seen to be playing politics and, even worse, being behind the curve, which could lead to aggressive tightening further down the road.

At City Asset Management we continue to be at the bottom end of our allowable fixed income weight per risk mandate. In fact, we have gone further than this and have been, in my view, creative with the structure through the use of differing approaches. This has led to a mix of strategies, including floating rate notes, which should help weather rate rises, although investors should remain wary of the Libor floors.

The NB Global Floating Rate Income fund is our core holding here. The remainder is a mix of credit long-short through Muzinich, where we expect the manager to produce a modest absolute return regardless of market conditions, although this is not easy over the short term. We have some strategic bond managers with an absolute bent, in particular Nomura. Furthermore, we have recently added TCW, which is looking forward to a bond liquidity event. This manager is holding cash in the expectation that it will provide liquidity to the market.

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Mike Deverell is investment manager at Equilibrium Asset Management

We’re currently a lot more optimistic about fixed interest than we have been for some time.

For a while we’ve been very underweight in favour of property. However, while 10-year gilt yields remain low at around 1.8 per cent per annum, corporate bond yields have crept higher. The yield on the Iboxx Sterling Corporate Bond index has gone up to almost 4 per cent, after being around 3 per cent not that long ago. High-yield bonds have seen a similar move and look much more attractive than they did.

The average corporate bond fund has lost nearly 4 per cent since February. Any rate rise is unlikely to hit corporate bonds as much as government bonds as this is perhaps partially factored into prices already.

Liquidity is an issue and until there is period of market stress we won’t know how big this issue is. However, liquidity works both ways. From speaking to fund managers, they have often been trying to add to holdings on market dips, and have been unable to buy what they wanted as others did not want to sell.

Ultimately, while lack of liquidity may exacerbate volatility, provided there is no default your return on a bond is known when you buy it.

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Jonathan Davis is managing director of Jonathan Davis Wealth Management

Firstly, I should disclose my position: The Fed, and therefore the Bank of England, will raise rates sustainably when Hell freezes over. Each monthly decision is a coin toss now but any raise will come straight back down again.

Corporate bonds are unattractive to us at these extremely low yields, which are much like 2007 as I see it. Government bonds, however, remain wholly attractive as rates are low but are likely to go lower on a medium-term view. This is because we are in an era of disinflation and possibly deflation.

There are trillions of US Treasuries and Gilts and Bunds etc, so there is no liquidity concern.  There are many mutual funds and ETFs allowing access to government bonds, which we prefer. I prefer US Treasuries as I remain bullish on the outlook for the US Dollar on a medium to long-term view, which ties in with my bullish view of deflation and government bonds.

Over the longer term, a strengthening US Dollar would likely be negative for most commodities and probably emerging markets. However, it is weakening now and this is positive for those currently.

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Independent view: 

Mike Bell is global market strategist at JP Morgan Asset Management

While it is true to say that corporate bond market liquidity has reduced since 2008, we would argue that concerns over a potential liquidity crisis are overstated.

Reduced liquidity can potentially lead to wider spreads than would otherwise be the case during periods of market volatility, but we think investors should look through the volatility and focus on whether company fundamentals remain intact. If the probability of default has not increased we would expect the volatility to be short-lived and to potentially present buying opportunities.

An increase in interest rates from the Federal Reserve would signal that the US economy is strong enough to no longer require the “extraordinary” support that it has been receiving since the global financial crisis. While this may cause a short term bout of volatility it should be consistent with spreads tightening as the economy continues to improve and monetary policy remains highly accommodative.

We see opportunities in global high-yield credit in particular, where valuations are pricing a high probability of recession relative to our expectations for continued economic expansion. Even government bonds – despite their low yields by historic standards – do not look likely to experience a large sell-off.

Federal Reserve tightening could lead to increased dollar strength, further dampening inflation and allowing for a gradual pace of rate increases in which real rates remain low. In this environment we would expect 10-year Treasury yields to be below 2.5 per cent. With the European Central Bank on track to increase its stimulus measures, this should provide support for credit spreads as the hunt for yield continues.

Investors should expect more volatility from here. Reduced liquidity could somewhat exacerbate that volatility but we do not expect a crisis and see opportunities in markets where valuations are too pessimistic about the outlook.