Bond market liquidity: one for the ages
Like a parade of music’s greatest hits, the past year in markets has been crammed full of noise.
Some of it is pointless static, but other market melodies could turn out to be as important as Dark Side of the Moon, Thriller, Nevermind and 3 Feet High and Rising. Well, to bond nerds like me, that is.
Equity investors have been lambasting record low volatility and worrying about complacency in the marketplace, I believe equity markets are actually very volatile – just in a different way than people are used to. There has been a double-digit correction in the FTSE All-Share every year since the global financial crisis. Sometimes more than one. Volatility – when it arrives – appears to be getting turned up to 11.
Share markets are not your typical entertainment for a bond fund manager, but I think it’s important to be sensitive to one of the true global measures of business and consumer sentiment. At the moment, the share market’s mood reminds me of the famous line from former-Citigroup chief Chuck Prince: “As long as the music is playing, you’ve got to get up and dance.” Citigroup made huge writedowns within months of his remark.
For all the retrospective pillorying of Mr Prince, he’s right: no-one knows what will happen in the future and there are risks to staying on the sidelines. If you refuse to invest until there is zero uncertainty, you would never invest and would lose your capital to inflation.
Bond markets are seeing similar pressures, but with arguably greater distortions from quantitative easing and forced purchases by pension funds for regulatory reasons. US treasury market volatility – or at least the best measure of it, the Merrill Lynch MOVE Index – is extremely low right now too.
In the corporate bond arena, liquidity has taken a large step down in the past few years. Dealer inventories have roughly halved from 2011 levels, and are on a completely different scale compared with what banks used to hold before the global financial crisis. With fewer bonds available and market makers less inclined to take overnight positions, spreads are now much wider than they used to be, potentially depressing trading further.
This duet of influences – a downward pressure on yields from monetary policy and lesser trading – could be leading to dampened volatility. Investors may be less inclined to sell holdings because of the greater difficulties in doing so. Added to this, recently the spread above government debt for non-financial bonds has been accounting for between 60% and 80% of the yield. That means making the right call on the creditworthiness of issuers is more crucial than ever, because any deterioration is likely to significantly hit your mark-to-market returns. Investors are incentivised to be more long-term in their investments and are less likely to change positions than perhaps they were in the past.
Meanwhile, an overriding strain running through bond markets is a lingering sense of unease. For some time now, most bond fund managers’ portfolios have been much shorter duration – and therefore less sensitive to yield changes – than in the past. Despite this stance, duration has actually provided strong returns over the last couple of years. Whether this was worth the risk they represented is another matter, however.
No-one knows when the music will change and what the tempo will be when it does. But it feels to me like this era of market tunes may turn out to be essential listening for future investors.