How to soften the bond liquidity crunch

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.

During this period, the regulator also uncovered:

• An increase in the amount of failed or rejected trades.
• An increase in the amount of time it takes to fill an order.
• A decline in dealer quote rates on electronic bond trading platforms.
• A slight widening of some quoted and effective bid-ask spreads.

This represents “a worrying situation” according to Oliver Stone, head of research and deputy portfolio manager at Fairstone Private Wealth, but says it was an important piece of research as the previous regulatory studies failed to address the issue of transactions that had not taken place.

Liquidity issues in client portfolios were brought to the fore in the middle of last year, and in severe fashion. Even before the proverbial dust had begun to settle after the UK voted to exit the EU, property fund investors sought exodus.

Run for the exit?

According to data from the Investment Association, total outflows from all sectors topped £3bn during June alone, with more than £1bn pouring out of the property funds.

In order to deter investors, and potentially burdened by the need to sell underlying assets, a number of large managers such as Aberdeen, Henderson and Standard Life, were forced to either apply large dilution levies or suspend trading completely.

In respect of dilution levies, investors were left with the choice to either remain in the fund or face a large exit penalty. In the case of Aberdeen, this was 17 per cent.

Given the devastating impact for investors, especially those failing to clearly understand the inherent risk of open-ended property fund liquidity, could the same drama spill into the bond market?

“It’s not out of the question that fixed income investors could run for the exit,“ says Mr Trindade, who adds: “The decline in the number of market makers over recent years means that if this happens, there could be a large drop in liquidity.”

Government bonds will almost always be more liquid than corporate bonds. Oliver Stone

This view is shared by Mr Stone, who says: “Should inflation and rates continue to rise, or a policy misstep be made, things could get ugly - especially given the huge proliferation of passive bond funds and ETFs populated largely by retail money that is ‘hotter’ than traditional institutional money.”