The great bond liquidity drought...and how to fix it

Peter Lee
Published on:

Liquidity in the world’s bond markets has reached crisis point. Investors can no longer rely on banks to provide a crucial intermediary function in the secondary markets. It is time those fund managers started to think about providing that liquidity among themselves. If they do not, the consequences for the whole of the financial markets might be disastrous.

Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt. New regulations on the leverage ratio that will reduce banks’ repo funding books threaten to make matters even worse and to spread the drought from credit markets to rates, the underpinning of all financial markets.

Secondary markets are close to a breakdown that will soon imperil the primary markets on which companies and sovereigns depend for funding. All that is masking the decay is the extraordinary actions of central banks.

Their stimulus has created what looks like an asset bubble, siphoning abundant investor flows into bond funds all betting on declining rates and narrowing credit spreads. Asset managers’ trade-execution desks have been more worried about how to buy bonds than whether or not they...