Bond Liquidity Under Scrutiny

Terry Flanagan

There is no shortage of broad fundamental issues facing bond investors: Fed Chairman Ben Bernanke’s possible departure, the duration of central banks’ quantitative easing, and clients’ pressing need to earn more yield.

But for day-to-day business, concerns pertaining to market structure and regulation take precedence.

Sage Advisory Services Co-Founder Robert G. Smith III recently participated in a fixed-income roundtable event with top people from the U.S. Securities and Exchange Commission and key market participants such as BlackRock and JPMorgan.  “It was all about liquidity, and whether electronic market-making systems can satisfy the needs of the market,” Smith told Markets Media.

Some strategists are bearish on fixed income. Market conditions exacerbated by multiple QE interventions in the U.S. and elsewhere have slowed an economic recovery, some bond investment advisors say. They say the efforts have been helpful for banks needing to repair their balance sheets, but destructive to annuity companies and U.S. savers.

Advisors worry that recent strength in the U.S. equity market is not based on fundamentals. “We may be creating another bubble, and that bubble may be the stock market, not bonds,” one said.

Being able to bid is another worry. Bonds are getting marked up, with high yield now up to 105 to 107 cents on the dollar. Some market participants have expressed a general concern that prices won’t revert to par.

While central bank policies have accelerated money flow into the markets, capital commitment hasn’t increased, and the SEC may be taking notice.

Sage factors in less depth in fixed-income products when buying and selling. “We use a variety of systems – electronic, voice, regional dealers, plus Wall Street banks – to source liquidity,” Smith said.

Risk-management techniques for assessing liquidity and anticipating issues are a common theme among fixed-income advisors.

Smith said Sage works to identify market makers that will work best with clients on both more liquid and less liquid days.

He referenced the top 50 market participants banding together because Wall Street had not been able to provide the liquidity they were accustomed to. One concern about that is a potential correlation to the ‘too big to fail’ argument about big banks, but it this market, the worry instead is that the largest market participants are ‘too big to move’.

Founded in 1996, Sage manages $11 billion and strives to be as adaptive as possible in its market strategies  to avoid extended time in illiquid investments. Smith suggests small advisors will do better by taking a similar approach. “People need to recognize you can’t exit as easily as you used to,” he said, and some yield crumbs can be left on the table if it is the best and most efficient way out.

Sage, when working with clients, tends to map out the next one to two quarters on a rolling basis. Currently, it’s “fundamentals be damned, we are trading on Fed monetary process,” Smith said.

Fixed-income managers also cited the need to offer very tactical diversification strategies for their clients, using products like emerging-market debt, bank paper, and high yield. Buy-and-hold is no longer an effective fixed-income strategy, some say.

Smith said Sage focuses on ‘natural users’ of the fixed income markets, and satisfying their needs for income in developing and executing strategies. He cited the study from AON recently emphasizing that 401K accounts need to be more income-focused to meet the needs of retirees.

“We see excess liquidity in money-market funds that has gone into stocks, but they are hot to the touch,” Smith said.

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