It would be no exaggeration to say that with the exception of Grexit and the spectacular collapse of the Chinese equity bubble, bond market liquidity is now the most talked about subject on Wall Street. The focus on illiquid markets comes years (literally) after the subject was first discussed in these pages, but over the past several months, pundits, analysts, billionaire bankers, and incorrigible corporate raiders alike have weighed in.
Make no mistake, the liquidity problem is pervasive (i.e. it exists across markets) and generally stems from a combination of central bank largesse, HFT proliferation, and the (possibly) unintended consequences of the post-crisis regulatory regime.
Thus far, illiquidity in Treasury and FX markets has been somewhat of a delicate subject as an honest assessment of the conditions that led to last October’s Treasury flash crash and that help explain similar gyrations in the currency markets invariably entails placing blame squarely with central bankers and algos run amok, and that risks upsetting both the central planning committees that are now in charge of business cycle “management” and the deeply entrenched HFT lobby.
As such, discussing illiquid corporate credit markets is easier if you find yourself among polite company. You see, the lack of liquidity in the secondary market for corporate bonds is a somewhat benign discussion because although it unquestionably stems from a noxious combination of regulatory incompetence and irresponsible monetary policy, myopic corporate management teams and the BTFD crowd, not to mention ETF issuers, have also played an outsized role, so there’s no need to lay the blame entirely on the masters of the universe who occupy the Eccles Building and on the "liquidity providing" HFT crowd that’s found regulatory capture to be just as easy as frontrunning.
But while explanations for the absence of liquidity vary from market to market, the response is becoming increasingly homogenous. Put simply: market participants are simply moving away from cash markets and into derivatives. Where market depth has disappeared, it’s become increasingly difficult to transact in size without having an outsized effect on prices. This means that for big players - fund managers, for instance - selling into ever thinner secondary markets is a dangerous proposition. And not just for the manager, but for market prices in general.
In Treasury markets, traders have turned to futures to mitigate illiquidty...
...while corporate bond fund managers utilize ETFs and other portfolio products to avoid trading the underlying assets...
With the stage thus set, Bloomberg has more on the move to smaller trades and cash market substitutes:
Sometimes less is more. At least according to investment managers trying to navigate Europe’s credit markets.
TwentyFour Asset Management capped a bond fund to new investors at 750 million pounds ($1.2 billion) and JPMorgan Asset Management, which is marketing a 128 million-pound fund, said smaller investments are more flexible in a sell-off. Other managers are also limiting the size of their trades and using derivatives to avoid getting trapped in positions.
It’s become more difficult to buy and sell securities as Greece’s financial crisis curbs risk taking and dealers scale back trading activity to meet regulations introduced since the financial crisis. The Bank for International Settlements warned of a "liquidity illusion" in June because bond holdings are becoming concentrated in the hands of fund managers as banks pull back.
"Liquidity is generally poor in corporate bond markets and in the U.K. market it’s thin to zero," said Mike Parsons, head of U.K. fund sales at JPMorgan Asset Management in London. "You don’t want to be in a gigantic fund where there’s potential for a lot of investors rushing for the exit at the same time. Smaller funds are more nimble."
"Without enough strong liquidity, it’s hard to execute bond trades in sufficient size or price to move portfolio risk around quickly or cheaply," he said. "The bigger the position, the harder it is to find enough liquidity to sell it or buy it."
Liquidity in credit markets has dropped about 90 percent since 2006, according to Royal Bank of Scotland Group Plc. That’s because dealers are using less of their own money to trade as new regulation makes it less profitable.
Euro-denominated corporate bonds got an average of 5.3 dealer quotes per trade last week, up from 4.5 recorded in January and compared with a peak of 8.8 in 2009, according to Morgan Stanley data. That’s based on dealer prices compiled by Markit Group Ltd. for bonds in its iBoxx indexes.
Liquidity is especially bad in the U.K. corporate bond market, which is being abandoned by companies looking to take advantage of lower borrowing costs in euros and investors seeking securities that are easier to buy and sell.
NN Investment Partners said it seeks to manage difficult trading conditions by diversifying positions and capping trade size. The Netherlands-based asset manager avoids owning large concentrations of a single bond and uses derivatives such as credit-default swaps or futures that are easier to buy and sell, said Hans van Zwol, a portfolio manager.
"We really want to stay away from positions we can’t get out of," he said.
The conundrum here is that the more reluctant market participants are to venture into increasingly illiquid cash markets, the more illiquid those markets become.
At the end of the day, one is reminded of what Howard Marks' recently said about ETFs:
"[They] can't be more liquid than the underlying and we know the underlying can be quite illiquid."