03 Nov 2016
By Dean Stewart
The U.S. bond market has seen periods of challenging liquidity in recent years. But do the same mechanics that influence liquidity in the United States hold true in other regions of the world?
In many ways, we believe they do. Overall, bouts of liquidity shortages are not limited to a particular geography; the factors that drive liquidity permeate all markets – making bond market liquidity a risk that investors around the world must reckon with.
Toward a better understanding of liquidity drivers
The following table summarizes some of our research into liquidity determinants, and it highlights our assessment of liquidity conditions around the world. Where there is enough evidence to do so, we point out countries or regions in which particular liquidity inhibitors are taking hold.
|Liquidity factor||Observations and assessments|
|Concentration of bond ownership||
Particularly in the U.S., bond ownership tends to be concentrated in institutions, often in mutual funds — including passive strategies like exchange-traded funds (ETFs). Bond dealers, who once held large inventories, have scaled down dramatically. This combination increases risk when it comes to liquidity in the U.S. (and in other developed markets as well). Another factor at work is that prolonged monetary policy has prompted bond mutual fund managers to reach out longer on the maturity spectrum, which might create friction when funds have to provide daily liquidity to meet shareholder redemptions. We believe ETFs could be particularly susceptible to liquidity challenges should redemption orders begin to stream in.
As the ownership structure within bond markets becomes increasingly concentrated as noted above, liquidity risks increase. Our line of thinking is influenced by what happened during the global financial crisis of 2008, when U.S. corporate bonds experienced a significant decline in liquidity. Similarly, during the so-called “taper tantrum” of 2013, when bond prices fell amid concerns of downshifts in monetary policy, liquidity was thin for bonds that were primarily held by mutual funds. Many fund managers were caught in the same trade, and they needed to liquidate quickly. But banks were not playing their old roles as equalizers, making it difficult for sellers to find buyers.
|Number of market makers available||
In advanced economies, market makers (sometimes referred to as dealers or dealer banks) are becoming less active in fixed income markets. Their inventories are down, partly due to regulations that limit the amount of risk exposure on each firm’s balance sheet. When dealers face these types of constraints on their inventories, market liquidity tends to deteriorate. This is being felt strongly in U.S. markets, perhaps more than any other market globally.
|Use of credit default swaps (CDS) instead of physical bonds||
By trading CDS instead of actual securities, physical bonds are traded less often, which in turn can affect liquidity. For instance, if an asset manager needs to conduct trading for shorter-term purposes (such as managing cash), it may make more sense to trade through CDS rather than the underlying bonds. (A CDS is a privately negotiated contract that essentially allows for the risk of default to be transferred from one party to another.)
Two regulatory notes, with some history:
In the realm of CDS, the European Union’s (EU’s) ban on short selling sovereign debt via uncovered default swaps has reduced the liquidity for those assets as well. Beginning Nov. 1, 2012, the EU banned uncovered CDS positions and required disclosure of all short positions in European sovereign bonds. These restrictions reduce the ability of investors to find counterparties for a given trade, rendering the contracts less liquid. The effects of the ban carried over to the European sovereign bond market, where liquidity conditions worsened as well. The International Monetary Fund (IMF) conducted a study analyzing bid-ask spreads for a sample of sovereign bonds, in which it looked at spreads three months before the ban and three months after the ban. The findings revealed that liquidity declined after the ban.*
On December 11, 2015, the U.S. Securities and Exchange Commission proposed Rule 18f-4 under the Investment Company Act of 1940. If adopted, the rule will have a significant effect on the use of swaps, including CDS, by open end mutual funds, closed end mutual funds, and ETFs.
|Recent regulations on banks||
Legislation introduced in response to the global financial crisis has, ironically, increased the possibility of liquidity deterioration. Today, the regulatory footprint stretches around the world. The global regulations that make up the third Basel Accord (Basel III), for instance, set clear conditions for bank capital requirements and make it more expensive for financial institutions to hold inventories. In a June 2015 speech, Bank of England Governor Mark Carney touched on these restraints when he said that “the combination of new prudential requirements on [banks] … has reduced market depth and increased potential liability.”
A number of empirical studies have shown that there is such a thing as an optimal trade size. Generally speaking, as trades become larger, so does the bid-offer spread, which is in itself an indicator of tighter liquidity. (This spread measures the difference between the lowest price acceptable to prospective sellers and the highest price acceptable to prospective buyers.) As a loose generalization, we can say that for a given slice of the fixed income market, a trade that is double the size of the average trade would cost about 40% more than a trade of average size.
In Europe and Australia, liquidity is typically more sensitive to transaction size, because their markets are not as deep as those in, say, the U.S. In times of crisis, we believe it’s reasonable to expect bid-offer spreads to widen more in Europe and Australia than in the U.S.
Liquidity is likely to remain in the spotlight
Investors usually pay careful attention to many characteristics of their bond allocations, but often pay less attention to liquidity. We think it should be the other way around. Where it once was an afterthought, liquidity is now among the major risks that investors ought to be sensitive to. We believe it is more important than credit risk and interest rate risk, particularly in the investment grade space, and should therefore be factored prominently into investment decisions — always bearing in mind that liquidity exhibits unwanted skewness; it can be abundant when not needed and turn scarce when needed the most.
*“Market Liquidity — Resilient or Fleeting?” International Monetary Fund, October 2015.