Government bond sell-off fuels liquidity fears

By:
Peter Lee
Published on:

Investor concerns mount as liquidity fragments; banks seek to aggregate orders.

trader concern-R-600

In mid May, with the sell-off in 10-year Bunds still unfolding, a trader told Euromoney his biggest worry is not sudden losses from the sell-off but the lack of liquidity it has revealed even in bond markets that had seemed immune from that problem.

"What most alarms us inside the market is that this has been price gapping," the trader said. "You don’t expect that kind of discontinuity in benchmark government bonds."

Jim Reid, head of global fundamental credit strategy at Deutsche Bank, notes that this episode is just the latest to reveal the frailty of market structure.

"Those of us in the credit market saw this close up with high yield in the second half of last year," he says. "However, that this is increasingly spreading up the top of the capital structure is a worry.

"It’s also a worry that these events are occurring in relatively upbeat markets. I can't help thinking that, when the next downturn hits, the lack of liquidity in various markets is going to be chaotic. These increasingly regular liquidity issues we’re seeing might be a mild dress rehearsal."

Worries about the inability to turn positions round when the big sell-off starts is now hard-wired into investors’ minds.

 fixed income investors survey logo 2015
 

Fixed Income Investors Survey

Between February and April, Euromoney surveyed thousands of bond investors – including asset managers, banks, insurance companies and hedge funds – asking them to nominate their favoured sell-side providers of credit research and the best bond issuers.

In the course of that survey, we also asked about their concerns around secondary liquidity and what solutions they might see to improve it.

In total, 1,924 investors responded to the survey. Asked how concerned they now are about the lack of liquidity and potential inability to turn round large positions without moving the market price, an eye-catching 80% of the sample said they were either reasonably concerned (44%) or very concerned (36%).

How concerned are bond investors about a fall in bond market liquidity, and the potential difficulty in turning round large positions without negatively impacting market price? 
                       Bond_sell-off_pie_1-2
Source: Euromoney Research Group Fixed Income Investors Survey, incorporating  Best Borrowers and Fixed Income Research

Two-thirds of these investors expect the situation to get even worse, with new pre- and post-trade transparency rules leaving 45% of them reasonably concerned and 17% very concerned that these regulations will further reduce liquidity. 

How concerned are  bond investors that regulatory changes to enhance pre- and post-trade transparency will further reduce bond market liquidity?
                       Bond_sell-off_pie_3
Source: Euromoney Research Group Fixed Income Investors Survey, incorporating  Best Borrowers and  Fixed Income Research

What’s worse, the majority doesn’t think the various new bond trading systems and protocols set up to address the problem will help. While they are open-minded about using other trading protocols beyond request for quote and transacting on exchange like all-for-all platforms or via crossing networks, 63% of respondents think these innovations won’t improve matters.

Do new venues for trade execution and new trading protocols offer a potential solution to poor secondary credit bond market liquidity?
                       Bond_sell-off_pie_2-2
Source: Euromoney Research Group Fixed Income Investors Survey, incorporating  Best Borrowers and  Fixed Income Research

Is there any good news out there? Asif Godall, head of traded credit for Europe at HSBC, tries to find some.

"Improved transparency has at least improved liquidity in smaller orders of $500,000 or less," he says. "It is true that while the size of the credit market has doubled since 2007, dealer market-making inventory has fallen by 80% or more.

"That said, however, we are turning over our books with much greater intensity and velocity than before the crisis. In most cases this is many multiples of previous turnover."

And there’s another reason to hope. Godall explains: "As credit markets have grown, distribution on many large bonds has become truly global across the US, Europe and Asia. So we have to be wary of saying that all investors will always face the same way at the same time.