Euromoney spent the last month talking to the people running markets businesses at many of the world’s largest banks. It’s intriguing to learn what they are not particularly worried about – the threat from new technology, the prospect of disintermediation, the deteriorating macroeconomic backdrop, finding buyers for financial assets. They know they can acquire the best fintechs; they retain a lock on bringing issuers and investors together and slowing growth is not recession, even if geopolitics is jumpy.
It’s depressing to hear what they are worried about, though. Time and again it is chronic illiquidity in credit markets that tops the list. This has been a problem hiding in plain sight since 2013. QE infinity has obscured it, but for how much longer?
UBS in its recent study “Market Liquidity: The real credit fear factor” points to the recent price action in high-yield bonds. In the fourth quarter of 2018, US and European high-yield bond spreads widened 210 basis points and 184bp respectively. In the first quarter this year, they snapped back 132bp and 133bp.
These are top percentile quarterly moves, happening rapidly and for no apparent reasons. Spreads widened when there was no recession and default rates were running below their historic average. Such big moves quite divorced from fundamental drivers suggest market dysfunction. Why is this happening?
One reason is the changing ownership structure of the market, with more credit now concentrated in the hands of mutual funds that are likely to sell when spreads are widening and less held by insurers and pension funds, which have been shifting allocation to longer-dated, illiquid markets such as private debt and equity.
The risk is heightened in Europe where government bond yields remain at or below zero, forcing investors into credit. And the danger is exacerbated because dealers, which once might have taken a contrary view and positioned in sell-offs for a recovery, now move with the mutual fund herd, so amplifying pro-cyclicality.
The ECB’s most recent survey on credit terms and conditions in securities financing and OTC derivatives markets shows rising numbers of dealers admitting to only a very limited ability to make prices in stressed markets.
UBS analysts argue: “This lack of willingness to provide liquidity is structural in nature, and will not be reversed unless regulations were to unexpectedly ease on broker-dealers.” And they suggest new European central securities depositories regulations due to come into force next year on mandatory buy-ins in the event of failed trades could put another serious dent in corporate bond liquidity.
If spreads can gap wider when there is no recession and default rates are low, where do the biggest dangers lurk when default rates rise and illiquidity amplifies the sell off?
“We believe high-yield credit and EU credit will face more liquidity risk in a downturn than investment grade and US credit,” says UBS.
No one can say they haven’t been warned, many times over.