A primary focus of regulators worldwide following the Great Financial Crisis in 2008 was to lower the overall market risk that large financial institutions were exposed to. As a result, regulations such as the Dodd Frank financial reform bill and Basel III took direct aim at reducing the inventory of bonds held on the balance sheet of large banks.
However, in solving one problem, the regulations may have created another: forcing a reduction in large banks’ bond inventory has removed them as a primary provider of bond market liquidity. I spoke to Keith Brakebill, Russell Senior Portfolio Manager, Fixed Income, to understand the potential implications for investors.
Todd: Let’s cut to the chase: should investors be concerned about bond market liquidity heading into 2016?
Keith: From the perspective of the average mutual fund investor, despite reduced liquidity – I’d say the risk of them not being able to sell at a fund’s NAV (net asset value – i.e., the value of a fund’s assets less the value of its liabilities) when when they want to is low.
From the portfolio manager vantage point, there are more implications, though. After all, liquidity – good or bad – influences potential return opportunities and the volatility of returns. For instance, lower liquidity can make it challenging to execute some strategies that require frequent trades, particularly in riskier, lower credit quality areas of the bond market. I expect bond managers will need to move incrementally and be comfortable with being more of a buy-and-hold investor than in the past.
Todd: You mentioned high turnover strategies potentially being harder to execute. What other types of investment approaches might be hampered by a lower liquidity environment?
Keith: The first that comes to my mind are passive bond funds, in particular exchange-traded funds (ETF). Market liquidity is a much bigger problem for the ETF market than it is for the bond market as a whole. That’s because passive fund flows tend to be dictated largely by the direction of returns in their assets. Low liquidity amplifies trading costs for passive investors because to satisfy their shareholder flows, the funds have to buy assets in up markets (when prices are high) and sell assets in down markets (when prices are low).
This problem gets exacerbated for investors of bond ETFs – particularly in the high yield sector. If the demand for high yield bonds declines, these investors may find themselves holding a portfolio declining in value as the ETF price corrects. That’s similar to the situation that happened after the demise of Lehman Brothers, when everyone rushed to sell at once.
We believe that for certain active managers, their willingness to replace the void left by the large banks as providers of liquidity presents a potential opportunity. Banks didn’t exit that line of business because it wasn’t profitable anymore – they left it because of regulatory changes.
Todd: What specific areas of the bond market do you anticipate being more or less affected by this issue?
Keith: We’ve observed from episodes of constrained liquidity in the past that no bond sector is totally immune. This even includes the U.S. Treasury market. Nevertheless the U.S. Treasury market remains the most liquid market in the world. We don’t expect this to change anytime soon.
At Russell, we are keeping a closer eye on the investment grade credit, high yield and U.S. dollar denominated emerging market debt markets. These are the areas of the market that have historically been most reliant on banks as the primary intermediary.
We expect the municipal market will maintain liquidity levels relatively consistent to the past.
Todd: How has the issue of liquidity changed your thinking as a bond fund portfolio manager?
Keith: It has certainly made me appreciate the potential benefits of additional return strategies – for instance global currencies and global government bonds – that can diversify away from illiquid credit assets. These additional strategies tend to be more liquid and can be a great funding source for Russell to purchase bonds in periods where market technicals push prices past the fundamental value making it a great buy for value-oriented investors.
Todd: Thank you Keith for sharing your perspective on bond market liquidity, its roots in financial regulation introduced after the Global Financial Crisis, the consequent risks for passive investors – and the potential opportunities for active managers as providers of liquidity and value buyers, as well as sharing a few alternative strategies that may help mitigate the impact of a liquidity crunch, should it come to that.