Bond sell-off highlights liquidity shortage

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Post-financial-crisis regulation forced banks to retreat from their traditional role as market makers. That has sapped some bond markets of liquidity, research and many investors suggest, making it more expensive to trade and helping to spur the sort of steep price moves hitting bond markets since Donald Trump’s election victory.

Put simply: When there are fewer people quoting prices, investors are less likely to get the price they want.

So some say that they’re changing how they invest. In addition to holding bonds for longer periods, they are piling into cash and turning to electronic platforms and dark pools.

It’s convincing investors like Hani Redha to just trade less.

Last month, Redha, a fund manager at PineBridge Investments, spent days plotting a portfolio of emerging market bonds, but ended up not buying them.

Traders at PineBridge – with $ 85 billion assets under management – found that switching out of their holdings of US investment-grade bonds and into the new portfolio had become too expensive.

“Whatever additional return you were getting out of that, you basically had to give it away through wider bid-offer spreads,” Redha said.

Many investors say they had an easier time buying and selling bonds before the financial crisis.

Regulations designed to make the financial system safer mean that banks increasingly just match sellers with buyers, rather than making markets by sometimes taking those trades onto their own balance sheets. Assets held by securities dealers have fallen to $ 12 trillion from almost $ 20 trillion in 2008, according to Federal Reserve data

In a speech on November 15, Stanley Fischer, the Federal Reserve’s vice chairman, said that any change in the way markets now behave is a price worth paying in “the broader context of the overall safety of the financial system.”

Bond market liquidity is notoriously hard to measure.

Some experts don’t even believe that it has fallen off in any meaningful way. That includes Fischer, who said that liquidity remains “adequate.”

Trading of corporate bonds fell off during the financial crisis, but investors now trade about $ 19 billion worth a day, well above the average of $ 12 billion they bought and sold in 2006, Fischer said.

There are, though, more bonds out there.

In 2008, about 3.5% of outstanding US bonds changed hands every day, and now it’s 2%, according to the Securities Industry and Financial Markets Association.

In research released earlier this year, the Bank for International Settlements also concluded that, while liquidity had held up in deeper markets such as government bonds, some trading of corporate bonds has “become more complex and time-consuming.”

Research also points to the greater expense of some trades. Before the financial crisis, the cost of trading $ 1 million in distressed corporate bonds would increase by about 0.7% when those securities had a ratings downgrade. Following changes to financial regulation the cost of a downgrade was an extra 2.4 %, according to the research by Fed officials.

Investors attribute part of the recent bond rout to a lack of liquidity, especially as funds tried to sell emerging-market debt. Yields on these nations’ bonds have jumped more than half a percentage point since the US election, according to Bank of America Merrill Lynch.

Bonds are selling off as investors anticipate higher inflation and interest rate rises under a Donald Trump administration. Yields on 10-year US treasuries and German government bonds have risen about 0.4 and 0.2 percentage points to 2.28% and 0.33%, respectively.

In the light of what they see as falling volumes, some investors say they are holding bonds for longer.

“We tended to shift our portfolio to more of a longtime buy-and-maintain strategy,” said Chris Iggo, chief fixed-income investor at AXA Investment Managers which supervises €679 billion ($ 729 billion).

Investors are also hoarding cash, which now makes up 5.8% of fund manager portfolios, the highest proportion since 2001, according to figures by Bank of America Merrill Lynch. Cash holdings have risen steadily since 2013, and that is despite the fact that ultralow and even negative interest rates makes it more expensive to hold.

That is because investors want protection from market swings, some say. They also want to be able to quickly buy up any bargains that these up-and-downs may provide.

Investors are increasingly turning to the myriad electronic trading platforms that have emerged to give them quicker access to dealers and allow them to trade directly between themselves.

Write to Jon Sindreu at jon.sindreu@wsj.com

This article was published by The Wall Street Journal

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