Liquidity in the US bond market has changed materially from the pre-crisis days of heavy dealer balance sheets and banks’ general willingness to assume risk. These changes have coincided with record corporate issuance and a persistent low-yield environment. As a result, many bond market participants have experienced a level of distress as they seek ways to adapt to a less liquid fixed income trading environment. Within this mailer, we travel through the “Five Stages of Bond Market Liquidity Grief” and consider how US bond market investors are navigating this challenging landscape.
Stage 1 – Denial
Many market participants seemed to expect that liquidity would eventually return to pre-crisis levels, an environment often categorized as one of investor speculation and 18 excess leverage. However, there is likely little chance that markets revert to the same levels of pre-crisis liquidity given the strict financial regulation that has since been put into place.
Stage 2 – Anger
Due in large part to the adoption of the Volcker rule, balance sheets have shrunk substantially since 2007. Many broker- dealers expressed frustration with the rule when it was put in place, as it severely inhibited their profit-making abilities. They could no longer act as intermediaries between buyers and sellers of fixed income instruments on the same level as they could pre-crisis. As a result, it has become harder and more expensive for fixed income investors to execute their strategies.
Stage 3 – Bargaining
Many large Wall Street banks, broker-dealers, and investment industry groups have pushed back on regulators to loosen the restrictions imposed by the Volcker Rule. “We believe the proprietary trading provisions of the [Volcker Rule] would drastically disrupt the liquidity that banking entities provide to our clients.”3 Their efforts have gone largely unrecognized.
Stage 4 – Depression
Fixed income market participants have been focused on the subject of liquidity since the introduction of tighter regulation. General consensus appears to be that the liquidity environment has changed significantly for the worse, and investors have become wary about the current state and how frequently the subject is cited in the marketplace.
Stage 5 – Acceptance
While the existence of liquidity is a key component of a functioning bond market, investors can find it difficult to quantify how much liquidity is actually needed. Many reminisce about the days of excess leverage and high levels of investor speculation, but given today’s regulatory environment, this pre-crisis period might not serve as a prudent benchmark for suitable market liquidity.
Today, investors with longer holding periods who employ lower-turnover strategies are likely to be less negatively impacted by market liquidity changes. When trading is necessary, managers who utilize more deliberate trade execution processes may stand to benefit. Investors that serve as liquidity providers will potentially be able to take advantage of attractive trading levels as forced selling situations push down prices creating attractive buying opportunities for managers with dry powder on hand.
As managers purchase securities for their portfolios, they must have strong conviction and be willing to hold the bonds for a longer period of time, if needed. When periodic cash flows are required, a bond’s coupon and principal payments can be utilized in lieu of outright sales.
Changes in the Very Liquid Treasury Market
The liquidity landscape has changed across most fixed income sectors, including the often considered risk-free Treasury market. Within the Treasury market, the ability to trade in large quantities has diminished. At the same time, primary dealers purchasing directly from the Federal Reserve (Fed) have been buying fewer Treasuries than in previous years, and the volume in which they trade has fallen. Despite these structural shifts, the size of the Treasury market has more than doubled since 2008. As dealers have purchased fewer Treasury bonds, US-based and foreign investors have stepped in – since the beginning of 2014, investors purchased a greater percentage of Treasuries sold by the Fed than dealers purchased, a trend not seen since the Fed started tracking the data in 2000.
Market participants moving through the stages of liquidity grief to “acceptance” will likely have opportunities to take advantage of market dislocations borne from strained liquidity. At IR+M, we employ a low-turnover, hands-on trading style. We remain committed to our bottom-up investment process as we construct diversified and high- quality portfolios to navigate these new market conditions. Going forward, we will remain cognizant of the risks associated with reduced liquidity and believe our approach will benefit our clients over the long term.
1Bloomberg as of 3/31/15
2Barclays as of 6/30/15
3SIFMA Asset Management Group comment letter re: Volcker Rule 2/13/12
4US Treasury as of 6/30/15
5Barclays as of 6/30/15
The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.