"When The Unwind Comes, It Comes Sharply As The Exit Door Is Tiny"

Fund managers who together control trillions in assets are starting to panic in the face of an acute bond market liquidity shortage.

Dealer inventories have collapsed in the post-crisis regulatory regime, eliminating the traditional source of liquidity in secondary corporate credit markets, while HFTs and central banks have combined to create the conditions under which USTs and German Bunds can, at any given time, trade like penny stocks (October’s Treasury flash crash and May’s dramatic Bund rout are the quintessential examples). 

This environment has catalyzed a shift away from cash markets and into derivatives, as investors move from cash Treasurys to futures...

...and fund managers look to offset diversifiable flows with ETFs whenever possible to avoid tapping the underlying bond markets...

This shift serves to make cash markets ever more illiquid as trading dries up. 

Some firms (Vanguard among them, according to Reuters) are lining up emergency liquidity lines to tap in the event of a retail bond fund exodus. The idea, it seems, is to use borrowed cash to pay out investors rather than sell the underlying bonds into an illiquid market and risk triggering a self-reinforcing market collapse. 

Others are simply moving to cash. TCW for instance, is now “the most defensive [it’s] been since pre-crisis,” while Ian Spreadbury, who manages around $5 billion over several Fidelity bond funds, did the unthinkable (for a mainstream fund manager) last week when he recommended investors use the nuclear option and hold physical cash under the mattress. Overall, bond funds now old 8% of their assets in cash — the most in at least 16 years. Bloomberg has more on how the only three things that matter in the bond market are “liquidity, liquidity, and liquidity”: 

There are three things that matter in the bond market these days: liquidity, liquidity and liquidity.


How -- or whether -- investors can trade without having prices move against them has become a major worry as bonds globally tanked in the past few months. As a result, liquidity, or the lack of it, is skewing markets in new and surprising ways.


Spain, for instance, must pay more to borrow money than Italy for 30 years, even though Spain is considered safer by credit raters. Why? The Italian bond market is twice as big as the Spanish one -- and, therefore, more liquid.


The same thing is happening around the world. Bonds in smaller, less-traded markets like Finland, Singapore and Canada are starting to fall out of favor. And with the Federal Reserve preparing to raise U.S. interest rates, investors want to know they can sell in a hurry if debt markets turn volatile.


Concern liquidity is drying up has intensified as the global bond rout that erupted in April erased more than a half a trillion dollars from sovereign debt and triggered swings some have likened to a once-in-a-generation event.


Aberdeen Asset Management Plc has already said it arranged $500 million in credit lines to fund potential withdrawals. In the U.S., regulators will meet with Wall Street firms to discuss how they can prevent post-crisis regulations and central bank policies from sparking a meltdown when the next selloff occurs.


Some investors aren’t waiting to find out. In Spain, where a slump in repurchase agreements and trading of bills sent government-debt turnover in April to lows not seen since at least 2012, they’re starting to demand a bigger premium to own the securities, data compiled by Bloomberg show.


Investors told the Bank of Japan this month that while bid-ask spreads are narrow for small orders, more sizable transactions can cause unexpectedly large price swings, according to minutes of meetings held on June 11-12.


Bond investors are fixated on liquidity after years of easy-money policies by the Fed and other central banks locked away trillions of dollars of supply and prompted everyone to crowd into the same trades.


Regulations designed to limit risk-taking have also caused big banks to back away from their traditional role as middlemen by reducing the number of willing buyers, exacerbating price swings and potential dislocations as the Fed moves to lift rates for the first time since 2006.


“When the unwind comes, like we’ve seen in the past few months, it comes abruptly and sharply as the exit door is tiny,” said Ryan Myerberg, a London-based fund manager at Janus Capital Group Inc., which oversees about $190 billion.

There's the crowded theater analogy again, and while it's become something of a cliche when used as a metaphor for illiquid credit markets, the fact that the bond "exit door" has shrunk rapidly during the same period over which HFTs and central banks have come to dominate the market certainly seems to indicate that however one wants to conceptualize "liquidity" (it's a somewhat amorphous concept), algos, regulators, and central planners have been instrumental in turning off the faucet.


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