Bond liquidity has been on the decline, sparking fears of troubled future. But how can this be addressed?
The speed and ease with which bond assets can be traded is becoming a key component of portfolio construction.
This is not to say it was previously ignored, but recent events and research suggest that the situation with regards to liquidity is worsening.
Despite the issues with open-ended property funds in 2016 being widely appreciated and understood, the position with fixed-interest securities could be more complex.
Bonds, regardless of their type and issuer, are generally used to stabilise portfolios and provide a cushion against falling equities in bear markets, but are still traded so can rise or fall in value.
For this reason, investors will generally place volatility at the forefront of the majority of investment strategies, with liquidity often taking a back seat.
However, this is starting to change and with the bond market being flagged by the FCA and other trade bodies for its dwindling liquidity, it is vital to understand how this can be achieved, as the potential implications for investors are severe.
“Liquidity is important to facilitate flows into and out of funds,” says Ben Bennett, head of credit strategy at LGIM, who explains that investors require flexibility within fixed interest instruments, to either hold until maturity or sell and use the funds for a different purpose or strategy.
“Depending on the client and on the fund, we’ll take that into account when choosing which bonds to buy and how much cash to keep in the portfolio.
"As market liquidity has reduced over the years, we’ve made sure we own enough cash and concentrate our holdings in particularly liquid bonds in order to provide the liquidity our clients need,” Mr Bennett adds.
Why is liquidity pivotal?
According to Nicolas Trindade, senior portfolio manager at AXA Investment Managers, liquidity is not only pivotal for investors, but also managers aiming to beat the market.
He says: “Without it, they [managers] would be vulnerable to out-of-market risk while also finding it difficult to disinvest. Tactical investing, characterised by trading with a short term holding period, relies on liquidity to generate alpha.”
Recent analysis of the bond sector supports the sentiment that a liquidity shift has occurred, and a concerning one at that. In February of this year the Financial Conduct Authority published a 12-page report amid growing liquidity issues in UK corporate bond markets, and found that a decline has been evident since mid-2014.
Citing previous research conducted by its chief economist’s department from 2008 to 2014, which found sparse evidence of liquidity deterioration, the most recent study from the FCA discovered ‘a moderate decline in transaction-based proxies for liquidity’ over the last three years.