Liquidity Issues in Global Fixed Income Markets

Liquidity issues in fixed income not only result in severe mispricing, they also spill over into other assets. If you cannot sell the bonds in your portfolio, you sell equities. If you cannot sell local currency bonds, you hedge by selling the currency. Obviously, these sell offs will creating cascading impact


The concept of liquidity is aptly named. The idea of liquid brings to mind the old saying that you do not miss the water till the well runs dry. It is the same with liquidity. It does not bother you until there is not any.


The general definition of liquidity is the ease with which someone can buy or sell something. Enlarge that definition a bit and it becomes the ability to trade an asset without greatly impacting the price of the asset you are trading.


Normally this is not a problem. Most markets tend to be very liquid. You just pull up your on line broker program. Pick an asset and push either the buy or sell button and like magic you get an email confirming the trade at or near what appears to be the market price.


This is supposed to be true one of the most liquid markets in the world, the US Treasury market. But two weeks ago there were some problems. On 15th October, almost a trillion dollars of US treasuries were bought and sold. This volume in itself is impressive, but what was more disturbing was the volatility. The yield on the 10-year treasuries dropped by thirty basis points in a matter of minutes. This extraordinary drop was not trigged by any important news event. Why it happened is unclear.


Many people credited the new American regulations. These are required by the post-crash financial legislation known as Dodd-Frank. Under that, law banks are restricted from keeping certain risky assets on their books. As a result, they have cut back their inventories of bonds by 75% since the pre-crash high of $235 billion. With smaller inventories, the banks are less able to act as market makers during times of stress.


This would be a reasonable argument except that the new law does not limit holdings of US Treasuries. Therefore, the panic selling has nothing to do with the legislation. One possible other culprit is the rise of more high speed trading with ultrafast computers. This is more likely because the programs used by the computers tend to be similar. So, when things start to go one way or the other, the computers act just like humans. They move in herds only much, much faster.


Another problem is that like computers asset managers also tend to act like a herd. This is not new. What is new is that they are using similar benchmarks and the largest funds have been increasing in size. So when the elephants move, they do it very fast and run over everything else.


The real problem with the fall in US Treasuries was that it happened in an extremely liquid market for bonds. A similar movement in other fixed income asset classes could be a real disaster. One example is Greek sovereign debt. Prices of the bonds of peripheral Europe have been rising all summer as their yields dropped. This reversed itself rapidly. Greek three-year bonds yielded 3.5% in July. By the middle of October, the yield had more than doubled to 7.6%. Liquidity evaporated and the bonds tanked.


Junk bonds were also hit. In the US, the average yield for junk bonds increased from 5.53% at the beginning of September to 6.61% today. During the past two months, there has not been any change in the economic picture. Thanks to Quantitative Easing (QE), default rates for junk are a mere 2.1% far below the historical average of 4.7%. The lack of liquidity in the European high yield market is worse than in the US. There are fewer pensions and insurance companies that can provide support and depth to the market.


Besides US and European junk bonds, the QE program drove many investors to both corporate and sovereign bonds in emerging markets. These include both those issued in the local currency and those issued in US dollars. Here again there are major problems with liquidity.


Many problems in emerging markets are due to foreign investors who rush in and then rush out again. The scale of the investments has exacerbated this situation. The Bank for International Settlements estimates that the top 20 global asset managers hold 30% of all emerging market bonds and equities. This is double the level 10 years ago.


This can result in major changes on smaller economic shocks. For example, the 2013 “taper tantrum” was a much smaller economic event (or even non-event) than the collapse of Lehman Brothers in 2008. However, the negative impact on yields in emerging markets was greater. The bid – ask spread for 10-year emerging markets government bonds has also doubled since 2010.


Emerging market governments have diligently tried to avoid these problems. They have attempted to issue long-term bonds in local currency to local investors. Sadly, they have failed. The share of foreign investors versus local investors has increased in recent years. The result is a systematic liquidity mismatch between potential portfolio outflows and the capacity of local institutions and market makers to absorb the outflows.


Liquidity issues in fixed income not only result in severe mispricing, they also spill over into other assets. If you cannot sell the bonds in your portfolio, you sell equities. If you cannot sell local currency bonds, you hedge by selling the currency. Obviously, these will create cascading effect.


The explosion of the equities markets on 31st October caused by turbo money printing in Japan might have indicated that the fears of liquidity are overblown. Except that at least on American exchanges. High yield bonds, preferred stocks, and emerging market debt hardly rose at all. While the Emerging Markets Sovereign Debt ETF actually fell along with precious metals and other commodities. It also does not help the slowdown in Europe, many emerging markets or probably even Japan itself. Instead, it may merely reflect the potential volatility to come except the future may go another direction.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)

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