By Jim Cielinski
Liquidity problems are brewing in the bond markets. This is not a new phenomenon. Cracks were appearing even before the global financial crisis of 2008, but the focus has undeniably intensified as the U.S. Federal Reserve raises the prospect of interest rate hikes and volatility across markets marches higher. Will this liquidity cycle end in tears? Many of the underlying assumptions needed to make an assessment are simply untested. Policymakers, asset managers and investors are all concerned - and with good reason.
A range of factors have contributed to the problem. The size of bond markets has ballooned in the last five years. In the corporate bond segment alone, where liquidity pressures appear most acute, the size of the market has nearly doubled. In the U.S., the stock of corporate credit has grown from $2.75 trillion in 2008 to $4.4 trillion today. Market growth has far outpaced the growth in traded volumes. Moreover, dealers are disincentivised from holding sufficient bond inventory to act as a market shock absorber. Dealer inventories of corporate bonds are no higher than they were ten years ago and now reside at a record low as a percentage of market capitalization. Finally, investors have changed. The growth in mutual funds and ETFs has led the way in recent years. A proliferation of momentum-style investors and more aggressive asset allocation means inflows and outflows into these products are subject to a high degree of correlation. If many investors move simultaneously, markets may suffer a severe liquidity drought.
Exhibit 1: The credit liquidity gap
Source: FRB, Haver Analytics, DB Global Markets Research
Over-the-counter markets of this size require market-makers with significant heft, something the corporate bond market is clearly lacking. Some point the finger at regulation. It has become significantly more expensive to hold risk assets as inventory, as regulators have acted to limit the systemic risks of banks and brokers. Most estimates suggest it is now 4-5 times more expensive to hold inventory to facilitate secondary market liquidity, effectively pricing market-makers out of the business.
Regulations have indeed hampered the ability of dealers to hold bond positions but it is implausible to label this as a root cause of liquidity problems. Elevated inventories aggravate liquidity problems rather than mitigate them. The explosive acceleration in dealer positions leading up to the crisis - and their subsequent collapse - were important contributing factors to the evaporation of liquidity in 2008. Moreover, inventories at 2-3 times today's levels would account for less than 3% of market capitalization and still be wildly inadequate to preclude a liquidity crisis.
Market infrastructure had no chance of keeping up with the deluge of liquidity-driven growth. Central banks have injected more than $4 trillion of liquidity into the global markets since 2008, dwarfing what was possible within the private sector. By their own admission, some of this was deliberately designed to distort markets, raise asset prices and foster liquidity and credit creation. Policymakers and investors have created a complex web that will prove difficult to unwind as liquidity is withdrawn. This is the core issue facing markets today, and policymakers are still in the driver's seat.
Liquidity can be defined as the ability to buy or sell an asset at a known price, in reasonable size and in a reasonable time frame. This reflects two components - market breadth and market depth. Breadth is best captured as bid/offer spreads and volumes, as well as the ability to transact in less liquid issuers. Market depth reflects the ability to accommodate large transactions. Market participants want both, but it is the latter that is more likely to be the culprit in a liquidity crisis. Market turnover is indeed down, as shown below, reflecting an inability of the markets to keep pace with market growth.
Exhibit 2: U.S. corporate bond turnover
Measured by daily trading volume annualised, divided by market cap
Source: FINRA TRACE, Bloomberg, 06/15
Current turnover remains at some 40% less than pre-crisis levels for investment grade bonds and 20% lower in high yield. This corroborates our view that investment grade is in the cross-hairs of liquidity concerns - it is a massive market that has yet to show any improvement in its liquidity profile.
Aggregate trade volumes paint a different picture. Investment grade and high yield volumes are up 45% and 55% from pre-crisis levels. In both cases, however, average trade size per transaction has fallen. The average trade size in credit is 37% smaller than in 2007. From a risk perspective, wider bid/offer spreads impose costs and inconvenience, but there is a key difference between a higher liquidity premium and a liquidity crisis.
The inability to transact large trades is troubling. A liquidity crisis, should it unfold, would most likely come as policymakers pull back on the liquidity reins just as investors retreat from risk-taking commingled funds, generating sizeable redemptions.
The scale of the potential problem should not be taken lightly. Exhibit 3 highlights the pool of assets now subject to short-term calls on liquidity. Most of these $50 trillion+ of assets are packaged in products that permit daily redemptions. This understates the true monetary amount that might be subject to short-term notice, as it excludes segregated accounts and defined benefit plans which theoretically could elect to do the same.
Exhibit 3: Growth in redeemable funds (U.S. $ trillion)
Source: Morgan Stanley, Oliver Wyman, 06/15
We can take some comfort from the fact that in past crisis periods, outflows of only 4-6% of assets occurred in the most severely affected sectors. Nonetheless, a broad-based percentage reduction of this magnitude would still be extraordinarily painful, particularly in fixed income.
What's an investor to do?
Regulators and policymakers have spent the last five years each doing what they felt was necessary to preserve the efficacy of markets and economies. For regulators, that has included tighter restrictions on banks and broker/dealers, so that the scale and interconnectedness of risks does not pose a systemic threat. Meanwhile, policymakers have combated persistently low growth and inflation with seismic increases in liquidity. It is as if policymakers want to fit more and more people into an ever-larger stadium, while at the same time regulators are sealing all but a single exit. This is not likely to end well.
The story of the journey is not overly critical, as the implications remain the same. Liquidity risk is being transferred away from traditional holders and onto asset managers and end-investors. There is only one conclusion - the risk must be managed.
There are a number of steps that managers and investors can take:
- Understand the drivers of the liquidity cycle and use them to inform the investment process
- Manage liquidity risk, but also seek to turn it into liquidity alpha
- Prepare for higher volatility
- Create internal controls and procedures to protect fund investors and manage liquidity risks
- Seek new solutions for both fund management techniques and market infrastructure
Liquidity is a dominant driver of market returns. Shifts in liquidity occur between central banks, consumers and corporations, influencing both the relative and absolute performance of economies and markets. Most importantly, aggregate shifts in global liquidity are highly correlated with market cycles. Liquidity events don't just happen. They are occasionally driven by exogenous events, but these tend to be short-lived unless the liquidity backdrop is deteriorating. Investors would be wise to spend more of their research budget on understanding these liquidity dynamics, which will likely be a lead indicator of other economic indicators.
Currently, the global liquidity cycle remains supportive of risk but trends are leveling off. Should the Fed tighten monetary policy, as we expect, it should not be enough to fully offset easing elsewhere and end the cycle. The Fed, after all, is merely moving policy from hyper-accommodative to accommodative. But the markets would be foolish not to see this as an important step in what will eventually be a turning point.
If markets are even remotely efficient, one would expect to be compensated for liquidity risk. There will be stages where liquidity risk generates strong excess returns. There will be others in which the risk is underpriced. Choosing to minimize liquidity risk wherever possible, without regard to the proper level of compensation, is sub-optimal. There are many tools that can be used to assess compensation for liquidity risk. A simple but crude approach is to assess whether credit spreads overcompensate for the level of default losses, as shown below.
Exhibit 4: Excess premium of spreads vs. default losses
Source: Merrill Lynch, Bloomberg, 06/15
The difference, or excess, can be viewed as compensation for liquidity risk. This comparison is necessarily backward-looking, but more sophisticated forward-looking models send a similar message. High-yield investors are currently compensated for default losses, but spreads are not overly cheap and liquidity premiums are modestly below average.
Investors must adapt and become providers of market liquidity rather than users of liquidity. As owners of the most stable pools of assets in the market, there will be significant rewards available to those that can step in and exploit liquidity-induced overshoots. The difficulties experienced in 2015 by many momentum strategies are probably a harbinger of what is to come. In a lower liquidity world, abrupt market shifts are not only more likely, but will also become increasingly more expensive to transact in. In this environment, nimble investors will have an advantage.
Central banks are no longer suppressing volatility but pushing it higher. The global provision of excess liquidity, when embraced concurrently and transparently, is a recipe for lower volatility. Policy divergence, as we are witnessing in 2015, is more dangerous. Volatility will remain elevated. While the causality between volatility and liquidity will remain suspect, it is safe to assume the two will act to exacerbate any reactions. Not all large market moves will be a reflection of poor liquidity, but poor liquidity is likely to shoulder the blame. Much of the story, however, simply reflects the normal maturation of the cycle.
A more comprehensive response is needed
The scale of the problem requires more than research and investment process alterations. Controls and procedures relating to investment vehicles are essential, as is a deep knowledge of one's client base. A range of tools are becoming critical for managing this risk, such as liquidity stress testing, liquidity scoring and the application of swing pricing for material inflows and outflows. Within funds, investment managers must seek new ways of gaining exposure to risks that might be more liquid than others. Risk budgets may need to be expanded, where appropriate, to ensure greater portfolio diversification. Risk management must extend well beyond traditional methods and consider the severe outcomes that often accompany liquidity events and produce spikes in correlation. Consulting with clients can help ensure clear and mutual understanding of the liquidity risks that different products encompass, and some clients may opt for different products and opportunity sets. Managers must also better ration capacity in products that are illiquid, large, or a combination of the two. Finally, managers must invest more in the people and tools necessary to transact quickly and efficiently.
Market infrastructure must also adapt. The nature of the over-the-counter market for corporate bonds is simply obsolete given the scale of the market. There are no simple fixes, however. Electronic trading platforms are expanding rapidly and appear poised to garner an ever-larger share for "business as usual" types of trades, but they are not viable for larger trades. The market has done a poor job of standardizing securities. Many large issuers have dozens of bonds outstanding, each trading at their own price and spread, hampering market depth and liquidity. There is little chance of this changing materially in the near term, and even if it did, newer technologies would still require enhancement to exploit this standardization. This will be a slow journey, but clients will benefit from deeper and more liquid markets, and it will only happen if all parties work together.
A crowded stadium with one exit?
Some have suggested that liquidity fears are overblown. In one sense, it is indeed ironic that this debate is taking place today. Record corporate issuance was witnessed in May 2015. More than $140 billion of high-grade bonds were snapped up by investors with little difficulty. Liquidity appeared overly abundant. But the fact that primary market liquidity and secondary market liquidity can be so divergent is, in our view, a reflection of what is wrong in markets today.
If central bankers are leading us into a crowded stadium with only one exit, we have entered willingly. The exit will be more difficult. Markets are unlikely to escape this cycle without witnessing some liquidity-induced accidents. Greece, for example, may be only one of several. There simply has been too much liquidity pumped into the system and quantitative easing is too blunt an instrument to have precluded some dislocations and imbalances from developing.
Markets may be more capable than we expect. Illiquidity is certainly not a new feature in this cycle, and it can help markets go up as well as down. Much of the rally in risk assets in recent years was aided and abetted by excessive monetary liquidity coupled with poor market liquidity, but illiquidity garners much less attention when prices are rising.
Liquidity cycles do not die of old age. Excesses tend to build up until they are deflated through more restrictive policy. Central bank liquidity will determine when this cycle ends. When it does draw to a close, markets will be far bigger than we have seen in previous cycles. Illiquidity will exacerbate the final stages but it will be unlikely to be the catalyst. Investors should ensure that they are properly compensated for illiquidity today, adjust their portfolios and keep a close eye on the global liquidity cycle for clues.
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