BIS Warns on Fixed-Income Liquidity

Terry Flanagan

The Bank for International Settlements has warned that some asset managers may be ill-prepared to manage bigger swings in sentiment in the fixed income market as liquidity has bifurcated.

The BIS Quarterly Review for March 2015 said that in the current environment, narrow bid-ask spreads for fixed income market makers should not be seen as a sign that liquidity risks are low as strong demand has meant that liquidity risks have shifted to investors.

“While many of these are well equipped to bear these risks, there are signs that liquidity buffers have been trending down in some market segments. This suggests that some asset managers may be ill-prepared to manage bigger swings in market sentiment,” added the report.

The quarterly review said the BIS had identified signs of increased fragility and divergence of liquidity conditions due to a cyclical decreases in risk appetite and tighter regulation. As a result market-making by banks has become concentrated in the most liquid securities while deteriorating in less liquid bonds.

The BIS said: “In the wake of the recent global financial crisis, several developments suggest that market-makers are changing their business models.”

Market makers are focusing on core clients that generate the most income in other business lines, covering a smaller range of markets or shifting from principal trading model towards an agency brokerage model. As a result, many market-makers have become reluctant to absorb large positions and consequently need more time to execute large trades.

Although sovereign bond market liquidity has recovered since the financial crisis, executing large blocks of corporate bonds has become more difficult for asset managers as trading is highly concentrated in the few liquid issues.

“The share of securities whose 12-month trading volume equals at least half of the number of securities outstanding has fallen from 20% to less than 5% in the US corporate bond market since 2007,” added the BIS.

While fixed income trading has become more difficult, the new issue market is expanding and assets under the management of investment funds that promise daily liquidity are growing as shown by the increasing presence of corporate bond exchange-traded funds.

“Bond markets are concentrating as key participants, such as asset managers, shrink in number but expand in size,” added BIS. “As a result, market liquidity may increasingly come to depend on the portfolio allocation decisions of only a few large institutions.”

The survey said demand is growing for electronic trading in fixed income. “Still, these venues are most commonly used only for a limited range of small, standardised transactions. And, ultimately, they tend to rely on the same market-makers that otherwise provide liquidity outside these platforms,” added the BIS.

In their Wholesale and Investment Banking Outlook, Morgan Stanley and consultancy Oliver Wyman said today that bank balance sheets supporting traded markets have decreased by 40% in risk weighted assets and 20% in total balance sheet since 2010. The outlook predicted that the largest wholesale sellside balance sheets will continue to shrink by a further 10-15% over the next two years.

“The impact of less liquidity has been masked by a benign, ultra low interest rate environment, but this is set to reverse in the US in the next 12 months, and could also reveal the side effects of quantitative easing pushing investors to less liquid securities,” said the report.

Morgan Stanley and Oliver Wyman said their survey of fund managers more than with $10 trillion of assets under management said many respondents cited liquidity risk in credit markets as their top concern.

“All were increasingly concerned about secondary market liquidity not just in emerging market credit and high yield market liquidity, but also US and European corporate bonds,” said the outlook. “Some also expressed concerns around areas of rates markets and emerging market foreign exchange.”

On average, European asset managers were more worried than their US peers as credit markets in the region are more illiquid, there is a relative lack of retirement savings compared to the US and there is more pressure on European wholesale banks.

Morgan Stanley and Oliver Wyman said that although electronic trading fixed income will increase from the 15% today, the share is unlikely to reach more than 25%.

The report said: “More importantly however electronification doesn’t improve liquidity in tail events, this would require more fundamental changes to increase standardisation, which in turn would bring trade-offs for issuance flexibility and investment portfolio construction. Similarly, while agency structures offer some benefits, they would not improve liquidity.”

BlackRock has said that the greatest opportunity in improving bond market liquidity lies in standardizing products and behavioural change. For example, the top ten largest US issuers each have one common equity security outstanding but more than 9,000 bonds outstanding in total.

“The end result is that corporate issuers have a large number of bonds outstanding, and trading is fragmented across that universe of bonds. Secondary market liquidity will not improve unless this fragmentation is substantially reduced,” said BlackRock.

Featured image by bahrialtay/Dollar Photo Club

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