The traditional safe haven of the investment grade fixed income market has grown dramatically following the financial crisis. Fixed income mutual and exchange-traded funds (ETFs) that offer daily liquidity have grown by 160% (AUM) since 2007, expanding by $3.6 trillion.1
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The high demand for fixed income coupled with access to cheap financing has also led to a surge in the size of the fixed income markets. Concurrently, regulation has meaningfully reduced the ability of market makers to provide liquidity. This has sharply increased our focus in both the liquidity risk embedded in the market coupled with how investors are managing this risk.
The post-credit-crisis landscape
In the aftermath of the financial crisis the investable landscape changed. Monetary policy worked to collapse short-term deposit rates, and successive quantitative easing programmes has helped to compress the term premium in government bond yield curves. There is now a lack of supply in the market for high quality liquid assets.
Investors have needed to find alternative vehicles to store capital that are perceived to offer both security and liquidity. Fixed income funds that offer daily liquidity have been a major beneficiary. The assets invested in fixed income open-ended funds and ETFs have grown by over $3.6 trillion to $5.8 trillion since 20071 (see Figure 1).
Regulation has meaningfully reduced the ability of market makers to provide liquidity
Over time, investors have become increasingly concentrated in a small number of large strategies. By the end of April 2015, the three largest investment managers in the IMA Sterling Corporate Bond sector accounted for 31.5% of the total assets, up from 22% at the start of 2007. The total capital invested in these funds has also increased by 263% from £5.7 billion to £20.6 billion. This is despite the number of strategies in the peer group increasing from 65 to 97 funds.2
At the same time, the traditional interest rate risk and credit risk associated with the investment grade market have both increased. The quality of the Barclays Global Corporate Bond index has fallen from A+/A to A-/BBB+ and now offers both a lower coupon (income) and a longer maturity (interest rate risk). There has also been an expansion in the issuance of lower-quality subordinated issues, partly for regulatory reasons, with the growth of the corporate hybrid and contingent convertible securities (which in some cases can see investors’ holdings written off completely).
The primary market
Primary market activity has been strong this year. Year to date, investment grade credit supply has reached roughly $420bn. This is over $60bn higher than the same period last year. Mergers and acquisition (M&A) activity within healthcare largely explains the increase.
Large firms have been looking to buy both innovative smaller firms and revenue streams to compensate for the expiration of some of their existing patents. More generally, credit fundamentals are in a stronger position than before the crisis however, there are signs that the cycle is starting to turn. More and more we are seeing proceeds directed away from refinancing towards areas such as M&A which often leads to an increase in leverage and a deterioration of credit fundamentals.
High demand has also meant that the quality of protection built into the riskier end of the bond market through covenants has been falling. Outside of anecdotal portfolio manager information, the Moody’s Covenant Quotient index shows a notable decline in score from 3.4 at the start of the index in 2010 to 4.3 in December 2014, well below the average of 3.7.3
Further evidence of the insatiable demand for credit can be seen in the new issue market. For example, at the start of June, Petrobras was able to raise $2.5 billion through a new 100-year bond in the midst of very high volatility in the government bond markets. The company has recently been embroiled in a scandal surrounding alleged bribery for contracts and has even had difficulty producing their accounting reports. The company is based in Brazil where there are issues with both the levels of growth and inflation. Despite all of this, the deal was five times oversubscribed.
The new providers of market liquidity
The change in financial regulation and the de-risking of the banking sector has had a meaningful impact and reduced the ability of market markers to provide secondary market liquidity. Figure 2 illustrates this decline in dealer balance sheets across corporate and mortgage-backed securities. The net dealer inventory of corporate bonds with maturities greater than 13 months peaked in 2006 at around $31 billion and has now shrunk to around $13 billion4. In addition, average daily turnover per bond has also declined by approximately 32% since 2006.5 As a result, investment funds are increasingly having to fill the void and acting as the main providers of market liquidity.
Investment funds are increasingly having to fill the void and acting as the main providers of market liquidity
The Governor of the Bank of England, Mark Carney, captured some of these risks in his speech at Mansion House in June. He suggested that the combination of new prudential requirements on dealers and structural changes in markets has had the effect of reducing market depth and increased the potential for volatility. As a result, the issues surrounding market liquidity is something that regulators both here and across the world are trying to address.6
The fear that now exists is how the market would react to a significant re-pricing of government bond yields. The lack of secondary market liquidity or the willingness of market makers to warehouse inventory may enhance losses and lead to a vicious cycle of redemptions across all fixed income funds.
That is something that we had a brief taste of during the ‘taper tantrum’ in 2013. The immediate effect was a dramatic re-pricing of the yield curve and a reassessment of credit risk. Panic led to selling across the board with nearly $82bn in redemptions in June (1.5% of the open-ended fixed income market). Redemptions out of fixed income in aggregate continued for the remainder of the year. Fortunately, in this instance, the high positive correlations across fixed income asset classes only lasted for a six-week period and, despite the sell-off persisting, credit spreads actually fell over the remainder of the year.
Evolution of the industry
The industry is becoming increasingly cognisant of the risk associated with a lack of liquidity. In our role as selectors of third party funds, it is important for us to factor in these risks when making recommendations. It is essential that we continue to develop our framework to better assess the liquidity risks associated with the investment firms we allocate to. Over time the style of fixed income portfolio management has evolved. Turnover rates have been significantly reduced and investors have pushed to increase flexibility while looking to diversify more across quality, regions, currencies and issues. Many investment managers have also developed technology to incorporate liquidity into their models for risk and investment decisions as well as enhanced trading capabilities, and improving their ability to source liquidity. Recently, the third party managers that we invest with have, on average, been increasing the quality and liquidity profiles of their portfolios while at the same time looking to reduce interest rate risk.
It cannot be underestimated that the reduction of market-making activities, the concentration of assets in strategies, and the skew in market liquidity to a small number of issues makes the market more vulnerable to short-term technically-driven sell-offs. The investment managers who maintain better liquidity profiles will be able to take advantage of these buying opportunities. The tail risk revolves around a protracted period of mass redemptions driven by a dramatic fundamental change. In such a scenario, the illusion of liquidity will evaporate from the market. However, given the low yield environment that currently exists, the still strong, albeit credit-deteriorating fundamentals and the lack of good quality alternatives, means the likelihood of this event materialising remains low. For now, all eyes remain focused on the Federal Reserve and the prospect of the first rate hike in nine years.
Term premium: the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short-term securities (a new one-year security each year, for example). Typically, long-term yields are higher than short-term yields, implying that term premiums are usually positive (investors require extra compensation to hold longer-term bonds instead of short-term securities). Term premiums cannot be directly observed but must be estimated from data on short-term and longer-term interest rates.
Yield-to-maturity: the rate of return anticipated on a bond if held until the end of its term.
Hybrid securities: hybrid bonds are perpetual in nature (though an option to call exists), and allow the issuer a degree of discretion over coupon payments. These bonds are subordinate to senior debt but rank higher than equity in the capital structure.
Contingent Convertibles (CoCos): these are debt securities that are issued by banks however, if a pre-defined trigger event occurs (usually based on bank capital ratios), the bonds are automatically converted. The conversion is usually into equity, however, on occasion they will be written down to zero.
1 Morningstar Direct
2 Morningstar Direct (2007 AUM Data available only for 57 out of 65 funds).
3 Moody’s CQI Index using a database of 2,400 bonds issues globally since 2010. This index ranges from 1-5 with 1 being the highest.
4 Pimco, Bank for International Settlements, Federal Reserve Bank of New York
5 Pimco, Citigroup, 31 December 2014
6 Mansion House Speech by Mark Carney, 10 June 2015