Illiquid assets

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GLOBAL INVESTOR 1.15 — 62 <strong>Illiquid</strong>ity in corporate bond markets No exit? The efforts of regulators to strengthen the financial system have led to both lower and more volatile liquidity in the corporate bond markets. As a result, investors could potentially find themselves in a situation where no one will buy. To properly manage expectations, and to be able to plan ahead, investors need to understand this new landscape and what it means. financial crisis in 2008/2009: global market activity is concentrated more in the most liquid securities like sovereign bonds, and less in riskier securities such as corporate bonds. According to the paper, this trend suggests an increased fragility of the latter. As data availability is limited, the International Capital Market Association, a self-regulatory organization, conducted a series of interviews with market participants to analyze the topic from a market view. The study, titled “The Current State and Future Evolution of the European Investment Grade Corporate Bond Secondary Market,” finds that liquidity in secondary European corporate bond markets has declined; interviewees described the decline ranging from “significantly” to “completely.” Another survey of large banks published by the European Central Bank (ECB) in January 2015 focused on Euro-denominated markets and arrived at similar results. More banks reported that their market-making activities for credit securities had decreased during 2014 rather than increased, and a further decrease is expected in 2015. The study also found that participants’ confidence in their ability to act as market makers in turbulent times had diminished in 2014 compared to 2013. Since the financial crisis in 2008, regulators have tightened rules on financial institutions to improve the stability of the financial system. Banks and dealers have subsequently strengthened their financial profiles and scaled back risky capital market activities. This structural change is especially important to bond markets as they depend on intermediaries willing to warehouse risk and facilitate trading activity. As a number of studies by governing institutions suggest, liquidity in bond markets has decreased since 2008: investors now find it harder to enter and exit positions or are incurring higher transaction costs. This could increase the risk of more severe price swings. In an extreme scenario, investors might find themselves trapped as nobody is willing to buy. Here, we take a closer look at this structural change in bond markets and how it interacts with current market conditions, and analyze what investors can expect. Corporate bond markets Compared to equities, the fixed income market relies more on dealers and over-thecounter structures, which makes it more decentralized and dependent on functioning intermediaries. Further, the market for corporate debt is much more fragmented than the market for equities as companies usually offer very few classes of equity, but a large number of different debt instruments. Within the bond market, different classes of debt exhibit different liquidity characteristics. The market for government bonds is perceived as more liquid compared to the market for corporate bonds, partly due to the different structures of securities issued. Governments issue in larger lots, have fewer maturities and usually do not add exotic features to their debt. The corporate bond market is much more fragmented and thus shallower. Moreover, in the corporate bond market, different risk segments exhibit different liquidity traits. Investment-grade debt is usually more liquid, while high-yield and emerging-market debt are perceived as less liquid. Declining liquidity raises awareness A number of recent publications by regulatory institutions and think tanks suggest liquidity in bond markets has changed. In November 2014, a paper published by the Bank for International Settlements on marketmaking activities found that liquidity in debt markets has shown a diverging trend since the Regulatory tightening a driver We believe that the decline in corporate bond market liquidity can be attributed to an increase in regulation in the financial sector. This matches with the ECB survey results mentioned above, as banks most often cited regulation and balance sheet capacity as reasons for a decline in market-making activities. The financial crisis in 2008 revealed a number of shortcomings of financial regulation. Since then, governing institutions have been actively improving and tightening the regulatory framework, thus leading to a reduction of market-making and trading activities by banks. The Basel regulations for banks have increased the amount of equity banks need to hold against their risky positions. This makes market-making activities, which require sizable balance sheet capacity, less profitable. Additionally, the newly introduced Liquidity Coverage Ratio and Leverage Ratio are steering banks toward holding more liquid securities, reducing high-volume/lowmargin business such as trading activities, and limiting their reliance on short-term funding. Moreover, banks have cut proprietary trading in view of, for example, the Volcker Rule in the USA. Proprietary trading has been a source of liquidity, especially during
GLOBAL INVESTOR 1.15 — 63 volatile markets. As a result, banks and dealers have reduced their fixed income trading activities since 2008 as well as their ability to warehouse risk and facilitate capital market activities. Conditions affecting structural changes The structural change stemming from financial regulation comes at a time of historically low interest rates fueled by quantitative easing programs adopted by central banks around the globe. On the one hand, we believe that this accommodative stance has reduced market uncertainty and thus eased investors’ concerns about liquidity. On the other hand, low interest rates have increased the corporate debt markets as companies take advantage of the lower funding costs. In Figure 1, we show the increasing gap between primary dealers’ inventory and the size of the US corporate debt market. Moreover, investors’ motivation to drop low-yielding government debt and pile into higher risk and most often less liquid securities has also risen due to monetary policy, in our view. This in turn adds to liquidity concerns again (see Figures 2 and 3). Liquidity most relevant in times of stress So far, the decline in bond market liquidity has not caused much of a headache for investors as corporate bonds are in good demand. However, it is quite easy to imagine a scenario of many investors exiting at the same time with no one willing to buy or provide market-making activities. In this case, liquidity would evaporate quickly, leaving investors high and dry. The modest decrease in liquidity in the last few years might therefore not be a good indicator of what to expect during turbulent times or in case demand for corporate bonds falls. This could, for example, occur when interest rates increase from their historic lows. We believe the asset management industry is particularly exposed to a sudden drop in corporate bond market liquidity. Investors’ expectations of their ability to redeem mutual fund shares or sell ETFs (exchangetraded funds) on a daily basis could reveal the low liquidity of the underlying bonds bundled into these funds. In case of a pronounced outflow from funds, many asset managers could be forced to sell into dry markets and incur significant losses. The Bank of England’s Financial Stability Report, published in June 2014, aims at extracting the liquidity premium inherent in bond prices by comparing credit derivatives and actual bond prices. The analysis found that the liquidity premium increased in European investment grade issues from approximately 50 basis points in 2007 to 200 basis points the following year. For European high-yield issues, the rise was even more extreme, from approximately 100 basis points to almost 1,200 basis points during the same period. This suggests that, in times of crises, investors chase liquidity and also quality. Furthermore, according to the study, the liquidity premium is fairly low at the moment. To us, this raises concerns that current market prices influenced by low volatility and low interest rates do not compensate investors enough for the ongoing decline in liquidity and a potential hike in turbulent times. Implications for investors We believe that investors need to recognize the structural change toward lower liquidity as well as the volatile nature of liquidity, especially buyers of higher-yielding corporate bonds. Certainly, liquidity is more relevant in turbulent market times, but we think investors should plan ahead and assess to what degree they rely on markets. If holding fixed income securities to maturity is an option, investors can shrug off liquidity concerns. If not, investors should analyze each case to see if they are rewarded for the risk of not being able to sell at their convenience. Investors are not alone. Supervisory institutions are increasingly aware of the structural changes in bond markets. A policy response to cushion abrupt movements is not unlikely, in our view. In the long term, we believe that the gap left behind by banks will be filled or that banks will adjust their trading activities to cater to their clients more specifically. As traded corporate debt is a substantial part of the financial system, new forms of trading are evolving quickly. Electronic platforms that rely on peer-to-peer trading instead of dealers already exist and are likely to grow. Another approach would be to standardize the corporate bond market more to reduce complexity and simplify trading and market making. A combination of both seems pragmatic to us as electronic trading requires standardized units to flourish. In the meantime, a closer look at how much an investor relies on liquidity when a security is purchased will help to avoid most of the concerns. Jan Hannappel Equity and Credit Research Analyst – European and US Banks +41 44 334 29 59 jan.hannappel@credit-suisse.com 01_Corporate debt market up A growing gap between primary dealers’ inventory and the size of the US corporate debt market is fueling liquidity concerns. Source: Credit Suisse, Federal Reserve, SIFMA Federal Reserve data 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 SIFMA data 250 2001 2004 2007 2010 2013 Outstanding corporate debt USD bn (US) (left-hand axis) Primary dealer inventory USD bn (US) (right-hand axis) 200 150 100 02_Turnover ratio down The turnover ratio of corporate debt is much lower than the ratio of Treasuries and the total debt market. The turnover ratio of the US debt market has decreased on average by more than 30% since 2007. Source: Credit Suisse, SIFMA in % 14 12 10 8 6 4 2 0 2007 2009 2011 2013 US Treasuries US total debt US corporate debt 03_Outstanding US bond market debt US debt markets have increased 14-fold from 1980 to 2013. Source: Credit Suisse, SIFMA USD bn 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 50 1980 1990 2000 2013 Municipal Treasury Mortgage-related Corporate debt Federal Agency securities Money markets Asset-backed 0
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