LIquidity may mean different things to different investors but we would define it as the ability to buy and sell bonds in decent amounts at a reasonable cost and in the desired timeframe.
Investors have long complained that they cannot access liquidity in a consistent and reasonable way, and banks, providing liquidity, do not always like it when bid-offer spreads narrow unless it is accompanied by increased volume. If your margin (bid-offer spread) shrinks, then revenues will fall unless volumes commensurately increase.
What is certain, though, is that the decline in liquidity we have been experiencing since the financial crisis erupted in mid-2007 is structural, not cyclical.
Stricter banking regulations have had the unintended consequence of increasing the cost of holding inventory on balance sheets for banks, triggering an active reduction in their corporate bond holdings and reversing the massive increase seen in the early 2000s.
While we have experienced a sharp decline in dealers’ inventories over the past seven years, credit mutual fund holdings have exploded in comparison, further exacerbating the decline in liquidity. This enormous flow of money into credit was driven by the aftermath of the Lehman crisis in a world where investors were looking for steady income in a lower growth environment. This is clearly illustrated by the fact that, in the US, banks’ inventories represented about 50 per cent of the size of credit mutual funds in 2007; now they represent only 5 per cent. The situation is very similar in Europe and the UK.
Volume, the broadest measure of liquidity, has held up well. However, this masks underlying trends that should concern all investors. Indeed, there are fewer large trades, and trading has become more concentrated in the most liquid (or least illiquid) bonds.
This means that investors trade what they can trade, which creates a vicious circle of illiquidity for the rest of the market. The less a bond trades, the more expensive it is to trade it, therefore the less it trades. In the sterling corporate bond market in particular, liquidity would be best described as patchy and never quite there when you most need it.
Interestingly, due to a shallower liquid credit market – £400bn comnpared with €1.6trn (£1.3trn) for the liquid euro credit market, for example – and the involvement of fewer market players, the bid-offer spread is twice as much as for the euro credit market. This is very important as it means that turnover has a direct impact on performance. Indeed, a turnover of 75 per cent per annum for the average sterling corporate bond fund would incur a performance cost of about 75bps and in the current low-yield environment with a 10-year gilt yield still at only 2.8 per cent, 75bps matter.
A normalisation of core government bond yields could actually worsen the situation as it could be a catalyst for retail rotation out of fixed income, with investors having been used to equity-like returns in the past decade. Assuming stable credit spreads, a 1 per cent parallel rise in UK government bond yields would trigger a negative total return of -4.2 per cent for the average sterling corporate bond fund over one year.
There is therefore a clear danger that negative total returns will prompt retail outflows, putting further negative pressures on fixed income. As a result, bid-offer spreads could widen in such a move impairing liquidity and increasing transaction costs significantly.
However, such risk is more relevant to the US than to Europe. In the US, over 19 per cent of the US corporate bond market is held by retail investors who tend to be total return investors. In Europe, the picture is different as retail investors do not represent such a large proportion of the European corporate bond market, meaning that it should be better sheltered against such retail outflows as institutional demand (including pension funds and insurance companies) will most likely be even greater for credit due to higher yields.
Being part of a large asset manager and managing different types of funds (insurance assets, pension funds, retail, for example) can represent a real competitive advantage as it can help improving liquidity substantially as two funds may have different rationale as to why one would sell and the other would buy the same bond (it may be a regulatory reason, for example) enabling us to bypass the banks and trade at mid-price.
Furthermore, investing in funds exhibiting a strong natural liquidity profile should be a key consideration for investors right now and one way of achieving this would be to focus on short-dated corporate bonds.
Firstly, this would enable investors to offset total return pressures in a rising yield environment as such funds would exhibit a low duration.
Moreover, a well-balanced maturity profile, with let’s say 20 per cent of the portfolio maturing each year, would allow investors not only to implement active strategies at a lower cost and easily meet redemptions but also to benefit from a rising yield environment as re-investing naturally occurs at higher yields.
Nicolas Trindade is portfolio manager of the Axa Sterling Credit Short Duration Bond fund