Is lesser liquidity in bond markets a good thing?

Lesser liquidity in bond markets could actually make the markets more resilient to market shocks, Aviva Investors’ Chris Higham says.

Global corporate bond markets have doubled since the global financial crisis, but liquidity has shrunk to a quarter of 2007 levels.

Higham says the reduced trading inventories has been a feature since the global financial crisis and bond managers have adapted.

He believes having fewer bonds in the hands of traders and prop desks and more on the books of long-term owners is actually a good thing. 

“One of the reasons the market went down so quickly was because it was the that banks got into trouble and they were the major holders of bonds,” he says.

“Now, they are in the hands of fundamental, long-term and natural holders of these assets: fund managers and institutional investors.”

He does not expect a wave of redemptions or a large liquidity shock to markets, but he remains aware of the potential. For that reason his range of bond funds holds higher cash positions than before the crisis.

Higham’s £224.5m Aviva Investors Strategic Bond fund holds 8 per cent in cash, although that is partly because he feels valuations have become stretched.

It also has a large position in extremely liquid short-dated government bonds.

UBS Wealth investment management director James Mulford says he does not believe the expected drawn-out turtle crawl of developed interest rates back to normalcy will cause a shock in the markets.

But if there is a rush for the exit, the inventory needed is simply not there, he says.

“While the size of the bond market has doubled since the start of the financial crisis in 2007, liquidity (as measured by dealer inventory) is four times smaller,” he explains.

“Therefore, in the event of a market shock, investors are likely to head for the exit via what has become a very small door.”

Because of that issue, UBS recently trimmed its house position in high yield bonds to 2 per cent overweight. It was as high as 9 per cent at the end of 2011.

Last month the FCA warned investors of liquidity risk in corporate bond funds because of thin trading of the underlying assets.

“Most of the time fund managers ensure that investors are able to buy and sell their units on any day,” the regulator said.

“However, in very extreme market conditions fund managers could become unable to sell sufficient quantities of bond holdings to fulfil redemption orders, leaving investors unable to sell fund units.”

Fidelity Strategic Bond manager Ian Spreadbury says the much-reduced bond market liquidity is likely to continue.

Sterling-denominated debt has grown slowly compared with the European and US bond markets, he says.

“In addition, active trading volumes have decreased in the years following the crisis as investment banks have scaled down their trading desks,” he explains.

“A greater proportion of fixed income investors are now ‘buy and hold’ investors such as pension funds and insurance companies.”

For that reason, he does not foresee a massive liquidity shock.

“While trading volumes are down, on the other hand a cataclysmic fire sale of corporate bonds has become less likely as a greater proportion of assets can be classified as ‘sticky’, he says.

Subordinated financials and high yield markets have become a frequent hunting ground for improved returns in the low-yielding world, but they are most likely to be struck by illiquidity, he warns.