Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, James Foster, manager of the Artemis Strategic Bond Fund, explains the potential impact of liquidity risk on the bond market and the strategy he is employing to mitigate the risk.
Worries about liquidity in the bond market are nothing new. We have been talking – and writing – about them for a number of years. But recent comments by the FCA’s head of market infrastructure, a report from the Bank for International Settlements and high-profile articles in the national press have made liquidity a topical issue. This is a welcome development. To this point, not enough investors have been aware of the potential risks.
The crux of the matter is that the bond market has become a shadow banking system. The reason is obvious: bonds give a yield, whereas banks and building societies don’t. Rather than holding cash deposits yielding next to nothing, investors have been lured into buying bond funds. With banks reluctant to lend, companies have increasingly turned to the bond market for funding instead.
The risks that investors are taking by participating in this shadow banking system have been disguised by 20 years of falling interest rates, which have driven bond prices steadily higher. Meanwhile, daily dealing – or real-time dealing in the case of ETFs – has encouraged a mistaken belief that bond funds can be treated as a higher-yield alternative to a deposit account.
The Retreat of the Market Makers
The liquidity risk is compounded by the retreat of investment banks from market making since the financial crisis. The inventory that banks held as market makers used to act as a ‘safety net’ during periods of market stress. Before the financial crisis, banks could absorb any forced selling, buying unwanted bonds and recycling them. This created a more orderly market. But well-meaning legislation designed to prevent a repeat of financial crisis has had unintended consequences. It has made holding inventories of bonds less attractive to investment banks. This increases the risk of a disorderly market should selling pressure arise.
On top of this, market makers are no longer being paid to take on risk. Bonuses have been capped and clawbacks introduced. That means bankers are being incentivised to keep their jobs rather than to take risks. This may be laudable from the point of view of reducing risk – but it is absolutely no help in creating a liquid market. It means market makers will only take bonds onto their own book if they know they can get rid of them again.
So, when selling comes through, alternative buyers will need to be found. And, eventually, they will: the need for yield won’t disappear overnight. The population is still ageing and this demographic trend will continue to support bond prices. Interest rates, even if they go up somewhat, aren’t likely to rise to 3% any time soon. But there could be significant disruption in the short term.
The Maths of the Market
That disruption could be particularly painful for holders of longer-dated bonds. The maths here is important. If a 3-year bond falls in price by 5%, the yield rises by around 1.8%. Obviously, a 3-year bond which has risen in yield to that degree is very attractive. For a 20-year bond, a 5% fall in price increases the yield by just 0.34%. I have used 3-year gilts as an example, so the yield would rise from 0.7% to 2.5% - almost four times. For a 20-year bond yield with a starting yield of 2.2% to rise by 1.8%, the bond would have fallen in price by over 23%.
I appreciate this is just maths, but sometimes investors forget the importance of duration to returns and losses, particularly after a long period of falling yields.
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. Large bond funds dominate the market for some securities.
Individual issuers often have a large number of different securities outstanding, many of which will be thinly traded. That is particularly the case in the sterling market, where around 50% of the assets are owned by a handful of investment companies. This means that trading in these bonds is often done internally – ownership passing from one fund to another within the same asset manager. So the secondary liquidity of any issue is minimal and the price discovery mechanism doesn’t work.
If these funds receive significant redemption requests and become forced sellers, there won’t be many alternative homes for some bond issues. That would put further downward pressure on prices.
A Strategic Response
How do we minimise the potential impact on our fund? First, by paying close attention to duration. Owning shorter-dated bonds is the most powerful insurance there is. Having a portfolio of generally shorter-dated bonds also gives us a steady stream of cashflow as they mature. We can re-invest this cash or, if investors in our fund happen to be redeeming their units at the same time, use it to pay them. Importantly, this cashflow insures us against the risk of becoming a forced seller should there be a market dislocation of some sort.
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