Illiquid assets

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