(April 10, 2013) — An increasingly illiquid corporate bond market could spell trouble for the largest funds, as regulators tighten their hold on the sector, a boutique asset manager has claimed.
Fewer market participants after crisis-time mergers, smaller bank balance sheets enforced by regulators, and the closure of prop-trading desks have led to poorer liquidity in the corporate bond sector, TwenyFour Asset Management said in a note to investors.
The boutique firm said this meant some large funds would struggle to move out of positions due to the size of their holding.
“There will be ample liquidity for a small high-yield fund that would be satisfied by trading in small size tickets, whereas in many circumstances the market makers are unable to offer the ticket sizes required by the colossal corporate bond funds that currently exist (forcing them into areas where liquidity is available),” the note said.
This might mean these large managers would have problems selling out of a large position at an unfavourable rate; but there is a larger issue.
The increasingly important issue for larger managers, however, might be them “having to forgo the benefits of bottom-up stock selection by increasing the number of their holdings in order to ensure acceptable levels of liquidity,” said TwentyFour.
All this would impact the performance of these large funds, but various parts of the sector are affected to differing degrees. The investment grade corporate bond sector has seen the largest drop in liquidity, the fund manager said.
Over the last couple of years, bond funds have seen large inflows, with only a slight blip at the start of 2013 as investors turned towards equities. However, investor assets continue to head to fixed income funds, research has shown.
As bonds are almost exclusively sold over-the-counter (OTC) rather than on exchanges, the problem is more difficult to quantify and makes any fall in liquidity more stressful to the market.
“In equities, the exchange gathers all the prices and interest in a share on either side of the trading quote, indicating how deep the market is at varying price levels. Transactions happen when the bid and offer meet and investors can be assured of best execution,” the note said. “In fixed income, each dealer has only a small piece of the puzzle and this, plus a profit motivation, drives a bid-offer spread. For investors it means having to work across many dealers to gain any meaningful insight into a given bond’s technical position.”
Clearly it is in a boutique bond manager’s interest to claim the big boys in the sector had a problem, but TwentyFour’s research showed that bid/offer spreads had widened in the corporate bond sector to such an extent that the evidence looks compelling.
“When interest rates begin to rise or should corporate credit concerns return in any meaningful way then the rush for the exit could be overwhelming, or at least be the major driver of volatility,” the note concluded.
To read the entire note, click here.