Warning sign
The problem of shrinking liquidity in the bond market first emerged in 2007 and is now recognised as an early indicator of the turmoil that was to come with the financial crisis. Back then, the appropriateness of bond prices in valuations became an issue, with some funds applying fair-value pricing to their valuations.
Fair-value pricing involved the fund group’s internal pricing committee working with the fund custodian and trustee to manually adjust the quoted price of a bond to the price the committee agreed it would likely command in the market. This, in turn, assured that the overall fund was priced more realistically, although sometimes it meant a lower valuation was a key element of ensuring investors were treated fairly.
In current market conditions, it is conceivable that a sharp rise in the selling of illiquid bonds, such as high-yield bonds, could result in a mismatch between screen and trade prices. Mounting concern over this liquidity mismatch and the subsequent knock-on effect on valuations has prompted key market participants and central bankers to voice their fears that many investors may not be suitably prepared for any major selloff in the bond market.
Both the US Fed and Bank of England are now closely monitoring the fixed-interest markets. Earlier this year in Davos, Mark Carney warned that the first interest rate rise in the US would “test the resolve of the financial system”, prompting the Financial Conduct Authority to work closely with the largest participants in the retail market to monitor the depth of liquidity
