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Fixed On Bonds

The Great Liquidity Debate Part 1 – Time to unlock the bonds!

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Ever since the Global Financial Crisis (GFC) there is still one topic which continues to be debated with numerous opinions between traders, fund managers and investors alike…the state of secondary market liquidity in the corporate bond market. The COVID March 20 sell off brought liquidity conversations to front and centre again, highlighting the need for a ‘liquid’ portfolio. With fixed income market structure continually evolving, it remains a subject that sits rightly at the top of discussions for an active fund manager. This isn’t the last time I will write on the topic and it is important to continually evaluate the great debate to continue to generate good investment outcomes for investors.
If we look at a definition of secondary market liquidity we can immediately understand why corporate bond liquidity is challenging but can also provide opportunities if focused on.  In ‘normal’ market conditions, I consider a liquid market to be where there is a balance of buyers and sellers and I am able to trade a position that does not lead to significant changes to the price of the bond. The speed of execution and information leakage is also minimal so I don’t disturb the market. Unfortunately, as we know this isn’t always the situation and as credit dealers we are familiar with phrases from counterparties such as ‘Sorry no bonds to offer’, ‘we are not involved’ and ‘I can show you a level on half the order’!
The basic characteristics of the corporate bond market can make it less liquid compared to government bonds and equities on the whole. Bonds are not homogenous with thousands of ISINs (unique bonds) with different currencies, maturities, seniority, ratings within the same borrower let alone the whole market. They mostly trade over the counter (OTC) through negotiation and not on an exchange and therefore prices can be less transparent. Bonds have market participants that have different motivations for investing which can cause an imbalance between buyers and sellers causing significant price differences between similar instruments.
However, despite the differences, it’s important to keep focusing and being aware of the different issues which affect secondary market trading as this can help maintain a liquid portfolio when selecting bonds. The debate on liquidity does contain an element of subjectivity and it could be argued that if you were the only seller with multiple buyers then you would consider your position as being liquid at the moment of trading. It should also be noted that without these differences in liquidity there wouldn’t be as many opportunities to generate returns for active investors.
Time to unlock the bonds!
A few years ago, one study carried out by CITI research titled O liquidity, where art thou? which really attracted my attention showed that a large percentage of the US corporate bond market didn’t actually trade very often despite there being thousands of ISINs. Approximately on average only 18% of bonds traded on any given day between August 2017 and August 2018. Even in the current environment it feels that this lack of inventory trading is still the case. As a credit dealer, searching for suitable inventory is one of the most important parts of the investment process. Bonds tend to be ‘locked’ away within asset manager portfolios, not on the balance sheets of banks and this issue has been exacerbated with continued Central Bank purchasing.
Traditional sell side brokers still have a significant role to play in the trading ecosystem, especially in stressed scenarios, but as trading protocols develop, being able to unlock liquidity and seek bonds from all corners of the asset management community is even more important than ever. The continued development of all-to-all protocols and platforms will play a larger role when trying to buy and sell bonds. Trying to engage with non-traditional players such as ETF providers will also widen the pool of liquidity available. Integrating technology and utilising your own market data to open up inventory on both the buy and sell side will be vital alongside traditional methods in best identifying investment opportunities. Information leakage also becomes an important factor when trying to minimise price movements in the market especially on less often traded bonds. Talk of a fixed income tape (publication of trades and prices) will need to be looked at carefully. Liquidity providers will still want to maintain the sensitivity of their positions but as the discussion develops this could lead to an improvement in pricing transparency and liquidity.
As the credit market structure continues to evolve so will the great debate on secondary market liquidity. But what is clear is that being passive with your inventory will no longer be the future, if as an industry we wish to increase liquidity. Of course, there are still markets which will remain less liquid than others, but the market is moving in the right direction to unlock the bonds!

Anish Shah
Senior fixed income dealer

Risks

Forecasts are not reliable indicators of future returns.

Government and corporate bonds generally offer a fixed level of interest to investors, so their value can be affected by changes in interest rates. When central bank interest rates fall, investors may be prepared to pay more for bonds and bond prices tend to rise. If interest rates rise, bonds may be less valuable to investors and their prices can fall.

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