“Article from The Telegraph…..liquidity crisis could fire up the next financial crash.
– Liquidity crisis could spark the next financial crash (Telegraph, March 21, 2015):
Traders warn of a global credit ‘meltdown’ if corporate bond markets don’t improve
For Norval Loftus, chief investment officer at Allegra Asset Management, trading corporate bonds is not as easy as it used to be.
“It’s like night and day compared with six or seven years ago,” the bond market veteran says. “There’s no comparison. It’s even tougher than it was six or seven months ago. It’s getting more and more difficult all the time.”
He is not alone. Investors across corporate bond markets are finding it harder to buy and sell company debt. And some investors are beginning to fear that the lack of liquidity will be the spark that ignites the next crisis in financial markets.
Liquidity is generally taken to mean the ease with which an investor can quickly buy or sell a security without moving its price. As regulation of banks tightens, the liquidity, particularly of European and US credit markets, has evaporated, prompting a host of regulators and central banks to sound warnings about the difficult trading environment.
A rate hike by the US Federal Reserve, which would be the first since 2006, could trigger turmoil. Given the bond market is much larger than the equity market, and investors have piled into fixed income in recent years, fears are growing that when credit investors attempt to sell bonds en masse, the illiquidity in the market has the potential to cause a crisis of a similar magnitude to the credit crunch.
Last week, the Bank for International Settlements cautioned that liquidity was concentrating in the most readily traded securities and that “conditions are deteriorating in the less liquid ones”. A week earlier, Edwin Schooling-Latter, the Financial Conduct Authority’s head of market infrastructure, said that the scant liquidity in corporate bond markets warranted “careful regulatory monitoring”.
Perhaps the most arresting warning came last November, when the International Capital Market Association (ICMA) surveyed investors, analysts and traders of European corporate bonds and concluded that the common fear was that a “meltdown” of global credit markets had become unavoidable.
It is not just company bond markets that have been affected. Sovereign debt may also be hit, with Robert Stheeman, the head of the UK Debt Management Office, warning on Wednesday that the gilt market is potentially threatened by falling liquidity.
Similarly, the violent and unprecedented “flash crash” in 10-year Treasury yields last October was blamed on faltering liquidity. The sudden drop in yields was all the more extraordinary given Treasuries are considered to be the most liquid market in the world.
But it is the corporate bond market where worries about trading conditions are most acute. The ultra-loose monetary policies pursued by the Fed, the Bank of England and the European Central Bank has resulted in a torrent of bond issuance in recent years from companies seeking to capitalise on rock bottom interest rates.
“Now is the perfect time to borrow if you’re a company,” says Gary Jenkins, a credit strategist at LNG Capital.
European and British companies, excluding banks, sold a combined $435.3bn (£291bn) of investment-grade debt last year, and $458.5bn in 2013, according to Dealogic. The level of issuance is much greater than before the financial crisis. In 2005, for example, $155.7bn was raised from corporate bond sales and $139.8bn the year before that.
Companies issuing riskier, high-yield debt have been similarly prolific. Last year, European businesses sold $131.6bn of so-called junk bonds, up from $104.4bn in 2013, the Dealogic data show. In 2005, they issued $20.4bn.
At the same time that issuance in the primary market has grown, trading of company bonds by investors in the secondary market has dried up, a liquidity shortage that ironically has been caused by regulators’ attempts to avert a repeat of the crisis that shook the financial system in 2008.
“Bank regulation is generally a good thing, but one of the unintended consequences has been the reduction in market liquidity,” says John Stopford, co-head of multi-asset investing at Investec Asset Management. “And that could come back to haunt us. People need to be aware of that risk and be prepared for it.”
Unlike shares, which are traded on exchanges, bonds are typically traded over-the-counter and investment banks traditionally played a key role in facilitating the buying and selling of bonds issued by companies.
But the regulatory crackdown on proprietary trading and increasingly stringent capital requirements, which have hit market-making activities, have forced banks to retreat from the market.
“Tighter bank regulation makes it more expensive for banks to hold bond inventories, which reduces their desire to provide liquidity to the market,” says Stopford. As a result, it has become much harder for investors to trade corporate debt.
“If you’re working a €50m block of bonds, there’s no way you’re going to get a price. So instead you have to chip away and sell €2m to €3m per day,” according to Andy Hill, ICMA’s director of market practice and regulatory policy. “A few years ago, you would go to your favoured bank with a large block, they would show you a price, they would take it onto their balance sheet, hedge it and then trade out of it. Banks can’t do that any more.”
The impact of the fall-back by banks on trading has been dramatic. According to the Royal Bank of Scotland, liquidity in the US credit markets has dropped by about 90pc since 2006. Jenkins at LNG Capital says that the poor liquidity has prompted some fund managers to alter their investment behaviour altogether and buy and hold bonds until maturity, rather than selling them on and booking the gains.
Companies that have been flooding the primary market with debt have met voracious demand from investors hunting for yield in the low rate environment.
But the moment when bond investors change investment strategies and rush to sell bonds could soon be at hand.
Even though Janet Yellen, the chair of the Fed, last week indicated that a rate hike was not imminent, investors still expect the central bank to start tightening monetary policy at some point later this year. As the Fed moves closer towards its first rate rise in nine years, the pressure on bond markets is expected to mount.
“A signal that the US interest rate cycle is changing could be the trigger for the change in investor sentiment. Because Europe is in a slightly different phase, with the beginning of QE, it may not have much of an impact here, but certainly US high-yield debt, and emerging market bonds, could really suffer,” says Hill of ICMA.
A drop in liquidity is common during times of market stress, notes LNG’s Jenkins. Even so, there are fears that any looming sell-off would be exacerbated by the already illiquid nature of the market and the number of investors that have all made similar bets.
“We are in a position where pretty much every investor is positioned the same way,” says Hill. “When people start selling, they will all be sellers at the same time and that is a problem, particularly in the current climate.”
Since 2013 there have been growing expectations of a so-called “Great Rotation” out of fixed income investments and into equities. A concerted move into stocks would hit some bond funds hard, says Jenkins at LNG Capital.
“The problem might be if a huge bond fund gets redemptions because people are moving out of bonds and into equities. You’re going to have a situation where people become forced sellers and there’s no natural buyers.”
The trigger “would have to be that interest rates are going up because the economy’s booming and the equity market is booming with it.”
As well as the drop in the liquidity, a sell-off is likely to be intensified by consolidation among investment firms, which means the bond market now has fewer players.
“There are now some very large bond investors, some behemoths that have some enormous credit positions. Probably the most vulnerable are those with a heavy concentration of retail investors,” according to Stopford. “The demand for corporate bonds has so far been met by supply,” he says.
“The concern is that if investors at some point decide to offload corporate bonds, and a lot of people look to do that simultaneously, then we might find out just how much liquidity has declined.”