Regulators have their eye on the wrong ball over bond market liquidity, Hermes co-head of credit Fraser Lundie warns.
Following the global financial crisis, industry watchdogs have been focusing on investment banks, both their traders and their capital structure.
However, the real threat is massive bond funds holding illiquid securities they cannot sell, Lundie says.
Worried about an investment bank failure causing the credit system to melt down, regulators tightened the ropes on the businesses, which are the main source of liquidity in bond markets.
That led to a drastic reduction in bond inventory levels – a proxy yardstick – for liquidity. Dealer transactions are now at just a quarter of pre-crisis levels, while the market has more than doubled as companies tap extremely cheap financing markets for the first time and bank disintermediation grows.
While those changes are widely known, Lundie says, what is not highlighted is that many of those new companies are “€50m ebitda German engineering companies” or similarly sized minnows.
Much of that issuance is being snapped up in the primary market by large bond funds that have found themselves “forced buyers”, he says.
“There are maybe 20 or 30 people in the world who know anything about that company and they all own it.
“ETFs have had some bad press lately about being the potential epicentre of a financial shock. In my opinion it’s absolutely not the case. They hold massive companies that people around the world know something about. The possibility of liquidity is much greater.
“The regulators have been focusing on the banks when they should have been looking at me, fund managers, and that has allowed funds to get too big for the market.”
Those massive funds had already started to underperform because of the portfolio management difficulties that occur when holding hundreds of different, small bonds, he says.
The high yield market has seen the biggest changes since the global financial crisis, he adds.
“It has fundamentally and structurally changed. Up to 30 years before the global financial crisis it was relatively easy to understand: You buy a number of junk bonds knowing that some are going to default, but it’s fine because you get a nice big coupon from the rest for a long period of time.”
That meant there was scope for capital gain as well as income, an important driver of performance, he explains. The bonds were traditionally 10-year dated and un-callable for the first five.
“Since the crisis that’s halved, which has taken away a significant amount of high yield’s ability to provide capital appreciation.”
Also, the bond values are at unprecedentedly high levels, with investors buying at premiums, above the call price, effectively locking in capital losses.
“People are consistently buying CCC-rated bonds that can’t go up in value and you would never do that with an equity,” he adds.