Liquidity – or crucially the lack of it – has rapidly become one of the biggest risks to the global financial system, with leading central bankers publicly voicing their concerns over the past 12 months.
As the US tentatively embarks on its first rate hike for nine years, the challenges facing the fixed-interest market are clear for all to see. The collapse in interest rates has created an unprecedented search for yield, which in turn has created incredible flows to fixed interest.
There may have been signs of a reversal in the one-way flow of funds to fixed interest in recent months, but the volume of outflows is miniscule in comparison with the total volume of assets that has hunted for yield.
Yield hunters
Critically, the structure of the bond market has fundamentally changed during the past eight years, which has significantly affected underlying liquidity. With regulators taking a robust stance on making the financial system much safer, banks have focused on increasing their capital ratios. This has pushed banks away from the potentially higher risk areas of proprietary trading, which underpinned their business through the years preceding the financial crisis.
As a result, a significant provider of liquidity to the market has disappeared, with RBS recently concluding that liquidity had fallen by more than 70% in the credit market since the start of the financial crisis. It is during times of stress when these investment banks previously have been prepared to take fixed-interest positions on to their balance sheets, providing an exit route for investors who wanted to dump some of their holdings.
The biggest issue with the fixed-interest market is that it is an over-the-counter market that requires both sides of the transaction to be in place for a trade to be executed. Unlike the equity market, there is no market maker – which has the potential to create problems, particularly for bonds that are away from the mainstream and down the capital structure.
With no middle man in place to lubricate the market with liquidity, a seller has to wait for a willing buyer on the other side of the transaction. Of course, once the buyer knows the seller is holding something illiquid that he wants to sell, he is likely to offer a low bid to try to pay the lowest possible price for an asset.
This raises the issue of whether fixed-interest funds are entirely appropriate to be daily traded vehicles. Clearly, the majority of funds are daily traded, and this is fine when the underlying assets have strong liquidity. But the issue with bonds is that at times of stress they lose their liquidity, particularly as you look towards the high-yield market.
It could be argued that these funds would be better suited to weekly, or monthly, dealing in order to give the managers time to raise liquidity in an orderly fashion, rather than having to potentially sell assets at a sub-optimal price, which is not in the interests of any investor.
