Adrian Hull explains why an environment of lower liquidity in bond markets brings risks for pension schemes.
- The bond markets have become less liquid since the financial crisis.
- In March 2015 the Bank of England and FCA announced their intention to examine bond market liquidity.
- The current liquidity situation is a result of the desire of regulators to ‘decontaminate’ the financial system and make it less risky.
Before the 2007-08 financial crisis investment banks were able to extend liquidity to bond fund managers more or less at will. There was little downside to owning more securities and having a bigger balance sheet if that meant the bank made more money. However, since 2008 this has completely changed.
Firstly, banks were effectively forced to sell down securities they owned as funding them became almost impossible. Secondly, and more fundamentally, regulators across the world have made it less attractive for banks to hold traded securities. Banks now have to use significantly more capital to own bonds, making this a less profitable activity.
The result is that dealers within banks have reduced their inventories of bonds, which makes it harder for investors to trade larger positions. This has coincided with a search for yield driving more investors towards bonds, in many cases into exchange traded funds, which are particularly vulnerable to periods of market stress.
In March 2015 the Bank of England and Financial Conduct Authority both announced their intention to examine bond market liquidity in some detail. The two bodies have written to major financial institutions to investigate how market participants perceive and manage liquidity and the implications for the financial system and investors.
In our view it is important that pension schemes understand the importance of this issue and the potential impact on their portfolios.
So in an environment of less liquid bond markets, what can asset managers do to safeguard their clients' interests?
1. Liquidity should be central to any investment process
There is little to be gained from investing time and resources on researching issuers and bonds if these ideas are not sufficiently liquid to implement.
We consider liquidity at an early stage in our research process and never buy a bond without having a clear exit strategy. In terms of trading, our managers and central dealing team monitor liquidity in the market using multiple market venues. We also maintain direct and transparent relationships with the underlying counterparties to ensure effective execution of trades on platforms.
We have also greatly expanded our counterparty list over the last five years as banks have retrenched and refocused. We remain agnostic as to where we deal, focusing instead on ensuring best-execution for clients.
2. Be disciplined about capacity management
There is a risk that funds which attract large amounts of assets may be forced to compromise investment strategies to maintain liquidity.
We undertake detailed capacity analysis to understand the optimum size of any investment strategy. If any of our funds became large enough to create liquidity concerns, we would stop accepting new business.
For example, in early 2015 we restricted inflows from new investors into one of our absolute return bond funds to mitigate the potential impact of additional assets on liquidity and performance and protect the interests of existing investors.
3. Marking-to-market ensures transparency on pricing
During periods of market stress, such as in 2008 and 2009, many fund managers were forced to sell the bonds they could rather than those they wanted to sell. In some cases this was driven by managers not being prepared to realise losses. This can lead to higher-quality, more liquid investments being sold, leaving remaining investors holding less liquid assets with unrealistic valuations.
A fund manager's pricing policy is an integral part of the effective management of liquidity. We believe it is essential that a bond fund's assets are marked-to-market rather than accepting index prices. Only by doing so can stated net asset values reflect genuine trading prices that can be practicably achieved.
4. Ensure independent oversight of risk
In addition to management on-desk, liquidity is among the key risks monitored by our independent risk team. We conduct regular liquidity studies of our portfolios and examine liquidity factors within our risk and control meetings. Our chief investment officer also oversees liquidity in our clients' portfolios, with any concerns about emerging liquidity problems escalated to executive board level.
The current liquidity situation is a result of the desire of regulators to ‘decontaminate' the financial system and make it less risky. In doing so, they have pushed banks to reduce their exposure to quoted securities.
At the same time the quantitative easing programmes of central banks have helped to stretch the valuations of many bonds, while government bond markets have been exceptionally volatile, particularly in Europe.
Adrian Hull is a senior fixed income specialist at Kames Capital
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