Fixed IncomeJul 21 2014

Experts warn of ‘intense’ lack of liquidity in bond market

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Bond managers could be playing a dangerous game with high-yield investments given stretched valuations and the “intense lack of liquidity” facing the asset class, experts have cautioned.

The warning follows US Federal Reserve chairman Janet Yellen’s statement last week that valuations on “lower-rated corporate debt” are beginning to become “stretched”.

Ms Yellen’s comments echoed those last month from the Bank for International Settlements, which said the bond market is vulnerable to any switch from the current state of “euphoria”.

Tom Becket, chief investment officer at Psigma Investment Management, said the “intense lack of liquidity in corporate bond markets” is one of the main problems managers face.

He said a reversal in sentiment could send such a shock through markets that it could even affect equities.

The manager added that the “huge appetite” still present for bonds will continue to support markets for now, but he said “you want to get out before the party ends”.

He also said the illiquidity of markets means it looks likely that managers who do not get out in time could face significant problems.

Morningstar OBSR investment strategist Andy Brunner said managers who try to squeeze every last drop of performance from high-yield debt may find it difficult to sell out amid a correction.

Mr Brunner said investors need to question whether they are being compensated for the “substantial liquidity risk” in holding corporate bonds.

He explained that, without a stock exchange for bonds, trades are facilitated over the counter, but he pointed out that liquidity is drying up and “turnover in American high-yield bond markets is less than half what it was in 2007”.

Mr Brunner concluded that most market participants are now “hugely overweight an asset where the potential for excess returns has declined significantly and where liquidity is a major issue”.

He said that, on a six-month view, “credit will likely continue to outperform, led by riskier corporates” as the fundamentals still appear attractive, but he pointed out that the fundamentals “appeared” to be attractive in 2006-07 as well.

Daniel Lockyer, senior fund manager at Hawksmoor Investment Management, said the risk/reward outlook for high-yield bonds is becoming increasingly skewed to the downside.

He said that even the best-case scenario would only see the asset class grind slightly higher in the next year, adding that he “[does] not see the value in hanging on for just a couple of percentage points when the downside outweighs that potential benefit”.

But, speaking to Investment Adviser last week, bond managers from Axa Investment Managers, Kames Capital and Jupiter Asset Management said that, while they agree with Ms Yellen’s comments, they expect most investors to ignore the warning while the short-term fundamentals for high-yield bonds remain attractive.

The managers pointed to the demand for high-yield debt, the ultra-low default rates and signs of strengthening economies, particularly in the US and UK, as being supportive for high-yield debt in the near term.

Bond bubble?

Nick Hayes, manager of the Axa WF Global Strategic Bonds fund, said the bond market is now pricing in an “exceptional economic recovery”. He predicted that bond prices will fall when people become disappointed with a more modest recovery. He said bonds are likely to keep rising in the short term and that investors will continue to favour lower-rated debt in spite of Ms Yellen’s warning, but added he has been reducing his exposure to high-yield and emerging market debt.