Over the past few years there has been a tremendous amount of interest, discussion and analysis around decreasing liquidity in the fixed income markets. The Bank of England’s gilt purchases recently thrust the topic back in the spotlight, with the Bank having to pay a premium to get access to supposedly liquid government bonds. Given the renewed scrutiny, it’s worth outlining the factors constraining fixed income liquidity, and as importantly, how market participants can best cope with this decrease in liquidity. A fundamentals-based understanding predicated on long-term investing is particularly critical for insurance company investors, who tend to be deeply engaged in core fixed income as a function of both investment suitability and regulation.
Three major themes have driven fixed income market liquidity over the past eight years:
Capital markets perspective: a number of structural changes have impacted market liquidity. Regulatory changes have increased the capital cost of holding bonds for sell-side intermediaries. There have also been changes on the buy-side with a significant reduction in the number of leveraged / fast money investors (e.g. Structured Investment Vehicles – “SIVs”). Meanwhile, reduced issuance in specific markets hasn’t helped matters, as we’ve seen at the long end of the GBP corporate credit market, in contrast to increasing issuance in others such as USD investment grade corporate credit.
Institutional investors’ perspective: defined benefit pension schemes have closed down to new members and looked to reduce risk and match liabilities. Insurance companies are also encouraged to be better ALM matched as a result of Solvency II. Specific requirements in Solvency II, such as matching adjustment, require portfolios to closely cash flow match liabilities and investments to be held to maturity and sold only if there is material credit deterioration.
Central banks’ perspectives: The last eight years are unprecedented in terms of the amount of fixed income instruments purchased by central banks, with approximately $7 trillion of bonds purchased and currently held on central bank balance sheets. The current purchases announced by the Bank of England, European Central Bank and Bank of Japan have resulted in the highest level of central bank bond buying since 2009.
The factors above have had the combined effect of increasing demand for fixed income instruments, lowering the commercial incentives for intermediaries to make markets in these instruments, decreasing the amount of bonds in circulation, and increasing the percentage of holders of bonds who are relatively insensitive to price movement in determining their trading strategy and increasing transaction costs.
It’s unlikely that any of the above trends will meaningfully reverse in the near-term. Where does that leave investors grappling with structurally lower liquidity levels? Market participants are drawing on a number of tools to navigate changing liquidity dynamics. No single factor on its own will be sufficient and market participants must look at a combination of all these factors:
Widen your opportunity set: investors should explore diversification through complimentary asset classes and sectors with better liquidity and supply dynamics than the sectors they traditionally invest in. For example, we expect to see more GBP investors switching into Long US dollar investment grade credit for additional diversification.
Use every tool / instrument available: portfolio managers should look at utilising every instrument and tool available to them (ETFs, credit derivatives, etc.) to help them overcome liquidity challenges. Tactics could include buying ETFs at the commencement of a mandate to immediately get beta exposure in the portfolio and then sell out of the ETFs as cash bonds are purchased. Another example would be to hold a core portion of the portfolio and use more liquid derivative instruments (credit indices, index options, etc.) to manage portfolio risk as markets move. The intention here being to minimise the amount of turnover in the cash bond portion and minimise transaction costs.
Re-assess investment strategy: investors will need to be more strategic and less tactical in the management of portfolios given the reduced availability of bonds and the associated transaction costs. A ‘Buy & Maintain’ approach based on fundamental views with fewer cash bond trades that are tactical in nature may be the right approach. Portfolio managers will need to be investors and not traders and buy bonds issued by corporations with solid fundamentals and long-term visibility.
Be opportunistic and nimble: in this environment of decreasing liquidity, the quality, depth and structure of institutions’ trading desks and the access and relationships they have with market intermediaries will be vital. Portfolio managers will have to be nimble and quick to seize upon opportunities as they present themselves. A close relationship between traders and portfolio managers and a well defined trading strategy is going to be the key to success. An example of this would be buying bonds based on ‘axes’ and when bonds are available as they may not surface / trade again in illiquid markets.
The sooner investors fully embrace the reality of structurally lower liquidity, and marshal practical tools to counter it, the better. The summer’s resurgence in liquidity jitters suggests the challenge isn’t going anywhere.