Bond liquidity crisis masked by inflows

Bond funds are facing a liquidity crisis that is currently being masked by inflows to the sector, but that will be unveiled when rates start to rise, says Man GLG’s Jon Mawby. 

The liquidity crisis in the bond market could be larger than the money market failure in 2008 or than the previous asset-liability mismatch in structured investment vehicles, says Mawby, who runs the Man GLG Strategic Bond fund. 

Currently inflows to the sector are masking the liquidity issues in the bond market, which he estimates to be around 10 per cent or lower of pre-crisis levels in some instances. 

“At the moment we are seeing net inflows into the asset class which has masked the real liquidity problem, as more cash is coming in and issuers are trying to issue,” he says. “It’s a very different kettle of fish if we start to see net outflows.” 

The situation has been created by a toxic combination of QE, which means central banks own more and more underlying assets, and regulatory changes limiting the sell side and secondary market trading, says Mawby. 

Now investors are being complacent about the risk in bond funds, says Mawby, as in the backdrop of easy monetary policy many zombie companies have been allowed to keep going by continuing to issue cheap debt, where otherwise they would have failed. 

“As we move into an era of higher rates we will start to see that stimulus withdrawn from financial markets and start to see defaults pick up…or general volatility making people aware funds are not riskless,” he says. 

“Higher rates will generally start to force outflows from the sector, that could unmask the liquidity problem,” he says. 

“Regulators are paying lip services to it but they are not solving the problem. I think we are only just starting to see the mainstream pick up on the fact that a liquidity problem could potentially be there,” Mawby adds. 

Asset managers are now putting in credit lines to help facilitate outflows when they come, while others are looking at the idea of having cash balances across a firm’s funds, he says. 

At the point of a rate rise, when yields drop, outflows are inevitable, says Jason Hollands, managing director at Tilney Bestinvest. 

“Given the potential for these fixed income outflows to gather pace as investors adjust their thinking on interest rates, a potential fixed income liquidity crunch is a risk in the event of a stampeded for the exit,” he says. 

“In this respect a lot of asset managers will quietly admit that daily dealing is not at all helpful – as we saw when enhanced cash funds came under pressure during the credit crisis.” 

However, Kames Capital’s Adrian Hull thinks a rate rise will actually help liquidity in the bond market by removing the current uncertainty over when rises will occur. 

Kames Capital’s fixed income product specialist says: “There is an argument that rate rises in the US and UK may actually improve liquidity by removing the uncertainty that pervades markets.” 

“Liquidity has worsened in the last three months, but while it is not going to return to anything like pre-crisis levels, a rate hike will not make it worse,” he says.