Navigating a Liquidity-Constrained Fixed Income Environment
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Navigating a Liquidity-Constrained Fixed Income Environment February 2015 T. ROWE PRICE Investment Viewpoint EXECUTIVE SUMMARY Credit markets have seen a significant decline approach to managing liquidity risk in client in liquidity in the wake of the 2008 financial portfolios. Portfolio managers, traders, and crisis, as new government regulations have analysts continually collaborate to assess limited Wall Street banks’ proprietary trading liquidity conditions at both the market and activities. This has occurred alongside strong security levels. Quantitative tools provide investor demand for fixed income assets and additional insights into the liquidity profiles heavy corporate debt issuance. of portfolios and prospective performance As the Federal Reserve prepares to unwind under different market scenarios. unprecedented monetary accommodation, A shortage of liquidity could worsen market regulators have expressed concerns that if dislocations if rates rise markedly. But there rates rise and investors aggressively sell their are several factors that should temper the fixed income holdings, dealers’ constrained impact of increasing rates, and demand for capacity to absorb supply has the potential to fixed income seems unlikely to falter for long. fuel financial market volatility. In the current environment, global trading and In the view of T. Rowe Price’s Fixed Income fundamental research capabilities, along with Division, liquidity conditions are unlikely to a long-term investment horizon, are essential improve meaningfully anytime soon. With for meeting clients’ investment objectives. that in mind, this paper discusses our holistic Amid highly accommodative monetary Stimulus efforts from the world’s major policy, record corporate debt issuance, and central banks have dramatically increased the considerable investor demand for yield, money supply and, by extension, lifted asset liquidity in fixed income markets may appear prices. However, the global rally in financial ample. A closer examination, however, reveals assets has not necessarily translated into growing market strains against the backdrop increased market liquidity—that is, the ease of a looming increase in interest rates. of purchasing or selling these assets when needed, assets. In response, dealers have shed assets and scaled with a reasonable expectation of the execution price back trading activities due to the reduced profitability and a minimal market impact. of these once lucrative businesses. Low liquidity is not a new challenge for fixed income At the same time that market making has become investors. In contrast with equities, the asset class is more difficult for the sell side, the buy side has seen fragmented into specialized sectors and consists of fixed income assets under management swell. tens of thousands of different issues that appeal to Since the end of 2008, bond mutual funds and a concentrated, predominantly institutional investor exchange-traded funds (ETFs) have amassed more base. With the exception of the Treasury, agency than $1.2 trillion in inflows.1 Corporate debt products mortgage-backed securities (MBS), and repurchase have been major beneficiaries, as exceedingly low agreement (repo) markets, trading volumes for short-term interest rates, meager Treasury yields, and individual securities are low compared with stocks. a low default environment emboldened investors to Many bond issues are small or privately placed, and increase credit risk to earn higher returns. Assets in some never change hands. With most trading taking investment-grade and high yield funds surged from place over the counter through dealer intermediaries, $880 billion in December 2008 to about $2.1 trillion in 2 pre-trade pricing transparency is limited compared December 2014. with exchange-based equity markets. Changes in market structure and size have altered trading activity, particularly within the corporate REGULATORY CHANGES, CYCLICAL FORCES AT WORK bond space: Stricter government regulations stemming from the 2008 global financial crisis have increased these Although trading volumes rose in the wake of challenges by limiting the ability of market makers the financial crisis and have held steady at these to facilitate trades. The Dodd-Frank Act’s Volcker Rule higher levels, there was a corresponding drop in prohibits banks from trading for their own accounts— the average size of trades. (Figure 1.) With dealers previously an important source of offsetting market increasingly acting as agents, taking orders and demand for traditional buy-and-hold investors. And connecting counterparties rather than using their Basel III regulations, which are being phased in, require balance sheets to facilitate trades, large-block banks to hold more capital against risk-weighted transactions have become rarer. Figure 1: More Trades, Smaller Sizes Figure 2: Trading Volumes Lagging Market Growth ree-month rolling averages for investment-grade corporate bonds through Twelve-month rolling trading volume as a percentage of investment-grade December 2014. corporate debt outstanding through December 2014. 150% $900,000 Average Trade Size 900,000 800,000 800,000 125 Share of Volume 700,000 Number of Trades 700,000 600,000 600,000 100 500,000 500,000 Share of Trades 400,000 400,000 75 300,000 300,000 200,000 200,000 50 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Sources: FINRA TRACE and T. Rowe Price. Sources: MarketAxess, FINRA TRACE, and T. Rowe Price. 1 Source: Investment Company Institute. 2 Source: Investment Company Institute. 2 T. ROWE PRICE INVESTMENT VIEWPOINT Figure 3: Volatile Trading Costs from bond funds. The current market structure can Corporate bond bid-ask spreads through December 2014 handle low trading volume and turnover, but it could be 50 strained by a large and sudden reversal of flows. 40 International regulators have voiced concerns that large 30 outflows could lead to market instability, like that which briefly transpired in May–June 2013 when then-Fed Basis Points Basis 20 Chairman Ben Bernanke first discussed tapering asset purchases. The subsequent spike in rate and spread 10 volatility lasted for only a short time, however, as Fed 0 officials reassured investors that monetary policy would 2002 2004 2006 2008 2010 2012 2014 remain highly accommodative for a considerable period Sources: MarketAxess and T. Rowe Price. after QE3 concluded. Turnover—a measure of trading activity relative to In our view, bond market liquidity will remain market size—has progressively declined. (Figure 2.) constrained for the foreseeable future. It is unlikely In essence, trading volumes have not kept pace with that regulators will loosen rules intended to engender the expanding size of corporate credit markets. a more stable financial system. Encouragingly, electronic alternatives to the traditional over-the- Encouraged by robust investor demand and an counter trading model have developed in a number opportunity to lock in historically low borrowing of markets, providing additional counterparties with costs, corporations have issued an impressive which to trade. However, these innovations have not amount of new debt in recent years. Outstanding made up for the reduction in dealer capital devoted to U.S. corporate debt has grown from $4.5 trillion at trading activities. the end of 2004 to close to $8 trillion at the end of 2014.3 Average monthly trading volumes have T. Rowe Price’s Fixed Income Division is assuming that risen by much less. current conditions reflect the new reality, and we will Bid-ask spreads have narrowed in recent years but be managing liquidity in our portfolios with that notion remain slightly above their pre-crisis lows despite until conditions change. subdued volatility. Unable to take on more risk COLLABORATIVE APPROACH TO LIQUIDITY MANAGEMENT because of higher capital costs, dealers require To manage liquidity risk in client portfolios, we take greater compensation to intermediate trades and a holistic approach where teams of traders, analysts, supply markets with liquidity, making trading more and portfolio managers (PMs) collaborate closely to costly for investors. This is particularly evident evaluate liquidity at both the market and security levels. when risk aversion is high, as seen in late 2011 To further analyze portfolio liquidity, we employ various when bid-ask spreads widened as the eurozone quantitative tools to assess risk and test assumptions. debt crisis escalated. (Figure 3.) A team of 35 global fixed income trading professionals4 TIGHTER FED POLICY RAISES RED FLAGS has a firsthand view of market conditions. Dedicated Concerns about liquidity risk have gained more market to specific sectors, they review pricing and subscription traction now that the Federal Reserve is ending its asset levels for new issues; analyze bid-offer spreads, purchases and is expected to begin hiking the fed funds volumes, and depth in the secondary market; and rate later this year. The worry is that rising rates and examine supply/demand dynamics across maturities, falling bond prices will trigger widespread redemptions credit qualities, and the capital structure. Traders 3 Source: SIFMA 4 Includes 24 traders and 11 trading assistants and trading analysts. As of December 31, 2014. 3 regularly communicate these trends to PMs and As large Wall Street banks pared their trading credit analysts, who factor this information into their operations, smaller rivals and electronic alternatives investment