Much has been written in recent months about the mounting risk of a potential liquidity crunch in the bond markets, and for good reason.
Bond markets are, by their decentralized nature, less liquid than equity markets, and recent regulatory changes have certainly complicated the process of buying and selling fixed-income securities.
Many of the regulatory changes are fairly recent, and they happened for good reason: It would be hard to overstate how bleak the financial markets landscape looked at the end of 2008, and policymakers in the United States and around the world, through a series of unprecedented actions, brought about much-needed stability to the global financial system, particularly through various quantitative easing (QE) programs. However, the introduction of QE was matched by increased scrutiny of financial institutions in an attempt to prevent history from repeating itself.
According to Thomson Reuters, the number of updates that regulators worldwide issued relating to rule changes grew significantly in the last seven years. Fewer than 9,000 updates were issued in all of 2008, but that figure had more than quadrupled by 2014.1 Robust regulation is a good thing-it ensures transparency and stability and reduces unnecessary risk taking. However, as the burden of implementing these updated policies fell on financial institutions, it led, in part, to an unintended consequence: a reduction in bond market liquidity.
In the wake of 2008, banks globally embarked on a mission to deleverage, reduce their exposure to risk-taking activities, and boost their capital position. The years following the financial crisis represented a simultaneous mass derisking and dramatic increase in regulations. The result for the majority of financial institutions meant moving out of capital-intensive operations and reducing involvement in market-making activities, a development that has contributed to the deterioration of liquidity in the financial markets.
According to the Bank of England (BoE), dealer inventories in fixed-income securities have declined by 70% since the pre-crisis period while the stock of fixed-income assets outstanding has doubled. Looking at dealers' corporate debt positions, balance sheets today, at around $20 billion, would be almost 20 times larger had they continued to follow their pre-2008 trajectories. The consequences are measurable: The BoE noted that the average time required to liquidate a given position is now seven times what it took in 2008.2
As active investors, we have the ability to manage our portfolios to this reality, and have been for years. For example, we don't typically buy bonds that are part of a small issuance, and more recently we have been focusing on corporate issues of $500 million or greater. And we also limit the size of any single corporate issuer in the portfolio—our cap, at the time of purchase, is 1.5% of fund assets. On a more qualitative level, one of the first questions we ask ourselves before adding any security to the portfolio is, how do we exit this position? If the liquidity risk is too large for us to confidently manage, we will not hold the position.
This facet of our process—liquidity risk management—is a feature investors won't find in fixed-income exchange-traded funds and many index-oriented strategies. Market volatility tends to be a galvanizing force for investors: With the U.S. Federal Reserve now officially normalizing monetary policy and interest rates heading higher, it will be interesting to see how investors react, and which fixed-income categories find new homes for money in motion. We believe that in an environment of low yields, rising rates, and heightened liquidity risks, a flexible multi-sector bond strategy has much to offer investors.
1 Thomson Reuters, March 2015.
2 “The future of financial reform,” Bank of England, 11/17/14.