
Bond Market liquidity
Michael Matthews, Fixed Interest Fund Manager
The lack of liquidity in fixed income secondary markets has been a recurring theme in recent years. The reduced capacity of investment bank trading desks during the Global Financial Crisis shone a spotlight on the fragility of liquidity in fixed income markets (which unlike equities trade counterparty to counterparty directly) and in recent weeks we have seen liquidity once again severely tested. In addition to the challenge of banks’ balance sheet constraints, the market has also suffered from the logistical challenges of home working. This lack of liquidity has led to price declines that belie the image of investment grade corporate bonds as a low risk asset class.
Recent price declines have been very sharp indeed. Some long-dated investment grade rated corporate bonds have fallen more than 30 points from their peaks. Short-dated bonds have also suffered relatively significant price falls.
Luckily, governments and the monetary authorities have brought their recent experience with market crises to bear and responded rapidly and decisively with a wealth of measures designed to alleviate pressures. Most importantly from the perspective of fixed income liquidity have been the huge central bank bond buying programmes, the scale and intensity of which have dwarfed any before them. For example, the US Federal Reserve in the first two weeks has already bought more US Treasuries than it did during the whole of its entire first QE programme. The ECB announced its own programme, essentially unlimited in size and scope. The Bank of England also announced its own large quantitative easing programme as well as cutting interest rates to record lows.
The positive impact of this policy response has already been felt. Risk markets have for now stabilised and the primary market has reopened. Indeed, one of the more interesting features of this market crisis has been the strength of investor demand for new issues at a time of market stress. Order books last week were often very heavily oversubscribed. One explanation for the high demand is the fact that these new issues were from amongst the very highest quality issuers. Moreover, these issuers were offering yields noticeably higher than their existing debt. But nonetheless it is unlikely that any issuer would have been able to come to the primary market without the prior central bank intervention.
Despite the policy response and the reopening of primary markets, secondary market liquidity is still challenged, interestingly, particularly at the short end and amongst the higher rated credits. It has been difficult to sell AAA rated bonds, such as covered bonds, very short dated bonds and other securities where credit risk is not in any doubt.
We are once again seeing the resurfacing of pressures in money markets. Bank treasury desks that would be the natural buyers of these low risk securities are raising liquidity themselves. Coupled with a lack of interest from investment banks unwilling to use up valuable capital on bonds with little upside, it has felt like liquidity for low risk bonds has at times been worse than for riskier securities.
One potential solution to this problem could be for the central banks to tweak their corporate bond buying programmes to focus more on shorter duration bonds and to also this time include senior bank debt which would help overall liquidity and free up investors to take more credit risk.
In my experience, investment banks are more willing to bid on securities which offer higher upside and investors are better at pricing credit risk than they are liquidity risk. This can be seen by the relatively good liquidity in subordinated bank debt in recent weeks.
The flip side of the poor backdrop for liquidity are the now far more interesting valuations than I have seen for some years. Credit spreads for some of the safest borrowers are at multi-year highs and for riskier credits, yields of 5% or more are achievable. In comparison to a government bond market that yields next to nothing this has to be an attractive starting point with a medium-term view. But although I am minded to increase credit risk, I am in no great hurry. Given the uncertainties that we are faced with, I believe it’s prudent to continue focusing on maintaining good levels of liquidity as well as searching for higher returns.
Investment risks
-
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.
Important information
-
All data is as at 30/03/2020 and sourced from Invesco unless otherwise stated.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.