Only in a fire are the emergency exits tested properly. A big fear of bond investors is that some markets, weakened by changes since the financial crisis erupted in 2007, will not cope in stressed situations. When trouble hits, it will be much harder to match sellers with buyers – resulting in panic and precipitous price falls.
The past few weeks have been a fire drill. Talk about the possible ending of quantitative easing by the US Federal Reserve led to a rush out of emerging market and corporate bonds – especially by nervous investors who would have stuck to safer, more liquid government bond markets had central bank action to drive down interest rates not encouraged a global “hunt for yield”.
Since the June 19 Fed meeting, emerging market bond funds have seen outflows equivalent to almost 3 per cent of assets under management, according to EPFR, the funds data provider. High yield and investment grade corporate debt had seen almost 2 per cent and 0.6 per cent outflows by late last week – and those averages almost certainly mask much bigger swings in individual sectors and funds.
So how did emergency systems fare? Some anecdotal reports are scary; one emerging market investor complains trading was “by appointment only”. Corporate issuance dried up. In the relatively safe European investment grade sector, for instance, four out of the 10 trading days that followed the Fed meeting went without a single new bond launch – pointing to serious difficulties in secondary markets.
Yet spreads between bid and offer prices – a gauge of how easy it is to trade – widened only modestly compared with 2008, even in high yield, or “junk”, markets. The Financial Times has reported how exchange traded funds– which replicate the returns of different assets but, like stocks, are easily bought and sold – have come under scrutiny. The industry insists, however, that the apparatus behind ETFs worked perfectly during the turbulence.
Even if there is no need to revoke safety certificates, the worry is that systems have still not been tested in extreme conditions. Fund managers had time to prepare for a turn in bond markets triggered by the Fed – the possibility had been widely talked about beforehand. The next “shock” may be genuine. Situations could quickly get out of control – and we do not know what will tip the balance. If a fund has 10 per cent in cash or easily sold US Treasuries, it is easy to cope with, say, a 6 per cent outflow. But a 6 per cent outflow becomes dangerous when only 5 per cent is held in liquid assets.
One problem is that banks’ “market making” functions have been hit by the increased regulatory cost of holding bonds on their books. Primary dealers’ inventories of US corporate bonds have plummeted by 76 per cent since 2007 and they now hold just 0.25 per cent of outstanding investment grade debt, according to BlackRock.
The proliferation of issues makes the problem much worse: while General Electric issues just one type of share, it has more than a thousand bonds. Once issued, many bonds quickly become rarely traded museum pieces.
Increasing the potential for trouble has been the rapid growth of corporate debt markets, encouraged by the “hunt for yield” and companies refinancing at historically low rates. Whereas bonds may be designed to be held until maturity, many are held in retail funds traded on a daily basis.
Matt King, a strategist at Citigroup, calculates that back in 2007, a 50 per cent outflow from US mutual funds invested in credit products would have forced market-making banks to double their inventories. Now, a 5 per cent outflow would have the same result – unless someone else bought unwanted assets.
Could markets be made more liquid – and less vulnerable to violent price movements? Yes, but that does not mean they will. Possible solutions include the greater use of electronic trading platforms to match buyers and sellers. Regulators could help market makers, or step up warnings to investors about the dangers of a sudden liquidity crunch.
BlackRock has proposed another approach: making corporate bond markets more like equity markets. In a recent paper, the world’s largest fund manager proposed much greater standardisation in the timing and amounts of issuance by the largest companies. Existing bond issues could also be “tapped” to create a more liquid “curve” of bond maturities.
The snag is that, while greater standardisation might increase investors’ returns, it would reduce flexibility for companies and perhaps increase their funding costs. Do not expect any action until we get a real blaze.
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