Artemis’s James Foster has expressed concern that worsening liquidity in the bond market could lead to significant losses when interest rates pick up.
The low liquidity has stemmed from the withdrawal of market makers – such as investment banks – due to regulatory pressures that have led to them no longer being prepared to accept the risks of taking fixed income assets on to their balance sheets.
In the absence of the cushion of the bond inventories traditionally held by market makers, Mr Foster warned any fixed income sell-off could rapidly turn into a crash.
“The risks have been disguised by 20 years of falling interest rates, which have driven bond prices steadily higher,” he said.
Mr Foster, who is manager of the Artemis Strategic Bond fund, said when the bond market next sold off, managers could find it difficult to sell holdings as prices would be pushed down until sellers found the demand to offload their assets.
The risk was intensified by the closed-off state of the current market, he said. More than 50 per cent of sterling fixed income assets are held by a small handful of investment firms.
“This means that trading in these bonds is often done internally, ownership passing from one fund to another within the same asset manager,” he explained.
“So the secondary liquidity of any issue is minimal and the price discovery mechanism doesn’t work.”
If these dominant investment companies faced redemption requests and had to become forced sellers of bonds, the illiquid marketplace might not be able to cope, increasing upward pressure on yields, Mr Foster said.
The problem has escalated because with cash yielding next to nothing, more and more investors have been lured into bonds.
He said this had effectively turned the bond market into a “shadow banking system”, in which investors saw bonds as a higher-yield alternative to cash holdings, but failed to understand the greater risk.
Mr Foster thought the safest response was to focus on shorter-term bonds to ensure a steady cashflow as they matured, providing some insurance against the possibility of forced selling.
He said: “Clearly, this isn’t an issue today. Interest rates are still falling and bond markets are making gains.
“And it isn’t easy to predict what might cause a panic, but the liquidity problem is getting worse rather than better.”
