Thinking Ahead: Liquidity in Fixed Income Markets - A Changing Landscape

Liquidity in markets has always been a moving target. The willingness of people to buy and sell is constantly evolving and regularly influenced by where we are in the economic cycle, seasonal factors (such as year-end window dressing), and a host of non-economic considerations. These dynamics are important to any investment process – particularly under market stress – and the resulting fluctuations are something we monitor in real-time. Over the long-term, however, different forces drive liquidity. Structural factors, such as technological change and regulatory oversight, can have a lasting impact on how financial market transactions take place. On March 18, 2015, the Wall Street Journal featured an article titled “Investors Raise Alarm Over Liquidity Shortage,” highlighting this issue with the following set of charts:

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While they are correct in pointing out some of the key changes in fixed income, there is also more to this story, and the potential effects of these changes extend well beyond the scope of what they present. The first chart provides an example of what has been most plainly visible to market participants since the financial crisis: trading volume in US fixed income markets has declined. The sequence that follows, however, is less straightforward. The next chart shows brokers reducing inventories, and while this could lead to lower volumes – it is traditionally easier to buy or sell something you keep an inventory of – this importantly is no longer a given.

Inventories have come down to help brokers meet regulatory requirements, and this has forced them to change the way they do business. With less ability to warehouse financial instrument risk, they now act as agent in most transactions, effectively connecting the buyers and sellers. This change has been significant but does not lead directly to lower volume – in fact for other industries, such as retail, led by technology-driven platforms like Amazon Marketplace, the opposite has been true. So while this likely has an effect, reduced inventories can’t fully explain lower trading volumes for bonds, particularly when the holdings referenced in the final chart increased substantially over the period. The holdings data instead contains at least part of the missing link to lower volumes, and that is the growth of synthetic instruments, such as ETFs and derivatives, offering similar investment exposures with greater efficiency. The growth of synthetic instruments coincides almost seamlessly with declines in bond market volume. In the case of corporate bond ETFs, assets under management rose by more than $90 billion over the period from 2009 to 2014 when US bond market volumes saw their most substantial declines. The market for credit default swaps has also grown meaningfully, and with improved technology and the advent of central clearing this growth is set to continue.

What does this mean for investors?

Besides the obvious decreased liquidity for bonds and increased liquidity for related ETFs and derivatives, there may also be indirect consequences that are important to investors. Brokers will likely face less profitable, lower-margin business while shadow banks / hedge funds may see increased opportunities. The most important outcome, however, is something we see manifesting in the securities themselves: increased market risk. For brokers to maintain profitability with lower trading volumes, bid / ask spreads are likely to increase and this directly increases the volatility of the securities being traded. More importantly, bank balance sheets have traditionally acted the “shock absorber” for bond markets because of their ability handle large orders. With this no longer intact, large sellers are prone to liquidity spirals where investors act as a herd regardless of fundamental values. This not only can increase volatility, it also can increase the negative skew or “tail risk” in the returns for individual bonds.

How can this affect investment strategies?

The less liquid the strategy, the more likely it is to be affected by this changing market structure. Wider bid / ask spreads lead to increased transaction costs, and increased tail risks are akin to the crude but popular analogy of “picking up pennies in front of a steamroller.” In general, instruments that are paid a liquidity premium as part of their returns may contain more risk than prior assumptions would suggest, and this is an important consideration for investors moving forward. As markets are always changing this dynamic is nothing new, and we expect further changes to market structures in the future. In this context, the growth of synthetic instruments offers new avenues for investors pursuing liquid and efficient investment exposures, and this can create profitable opportunities alongside the aforementioned risks. With markets in transition what’s most important is to systematically identify these changes and adapt, using active risk management as the foundation for any investment decision.