When the news broke that the Fed¹ had discussed imposing exit fees on various types of bond funds to discourage the managers from cashing out on increasingly illiquid assets, the discussion about liquidity in financial markets entered a new phase.
Over the last few years, assets in active and passive bond funds have almost doubled, with passive products growing at an even faster pace than active. The reason many observers find this worrying is that the diminishing size of combined dealer inventory — one of the historical core liquidity providers for the bond market — has been slashed by more than 70 per cent since 2007 due to increased capital requirements and tougher regulations. As a result, banks have aggressively reduced the amount of bonds held for market-making purposes.
This reduced market-making combined with rising asset levels creates a potentially dangerous liquidity mismatch — particularly if a sudden rise in interest rates or a widening of credit spreads were to trigger large redemptions exacerbated by forced selling in passive funds. The resulting “fire sales” could severely hurt fund investors — hence the Fed’s exit-fee proposal.
Active portfolio managers, on the other hand, have found a solution in derivative instruments. Duration, curve and credit risk represent the main risk factors of any bond fund, and liquid proxy instruments exist for all of them. So when trading in underlying bonds becomes difficult or expensive, active managers can use derivatives to hedge their exposures. Such a migration in trading flows can result in an outcome similar to the one seen in early June, when the market for Japanese government bonds, the second-largest in the world by volume, opened late for several days because of a lack of matching liquidity. Many active fund managers turned to derivatives — including futures, swaps and CDS² markets — and were able to re-position their portfolios despite difficult trading in the cash market.
As a result, contrary to falling liquidity in cash bonds, liquidity in derivative instruments has accelerated. Outstanding contracts — as represented by open interest in the main US Treasury futures contracts — have doubled since 2009 even as weekly trading in corresponding US Treasury bonds has fallen by 32 per cent compared with last year.³ The global financial system has created some very deep pools of liquidity for the main risk factors that trade almost 24 hours a day: The big equity index futures, government bond futures and, to some extent, FX4
and volatility contracts are used to run funds with illiquid underlying positions.
Low Dealer Inventory and High Asset Levels
Point to a Potentially Dangerous Liquidity Mismatch
Source: Citigroup as at 17 June 2014.
Yet while markets can function on the back of these kinds of liquid risk-transfer tools for some time, the ultimate proof will always be in the underlying assets. Consider a hypothetical example of a large redemption in a bond fund: The fund’s portfolio manager can lock in current market levels and reduce the fund’s exposure to the bond market by selling futures and then carefully searching for liquidity in the more-difficult-to-trade bonds. However, the fund will bear a residual risk — known as “basis risk” or “idiosyncratic bond risk” — because futures are not an exact match for cash bonds.
The issue is that there can be times when this residual risk has a large impact on bond fund performance. Looking back at 2008, when most segments of the global fixed-income markets did not trade for weeks and spreads became so volatile that proxy hedges lost all merit, derivative instruments were less effective. If this were to happen again, the illusion of liquidity we are experiencing today may be revealed quite drastically.
Consider that the current extreme of low yields and tight credit spreads makes the price sensitivity of bonds significantly higher than it has historically been. How will investors react to falling prices in case of rising yields or widening spreads? It remains to be seen, but even if history does not repeat, it tends to rhyme — and the chances of herd behaviour should not be underestimated.
While active funds have a wider toolset than passive funds and a mandate to cope with such periods of stress — maybe even use them to their advantage by providing liquidity — the rapid growth of ETFs and passively run assets poses a new risk to the market. These portfolios will still be obligated to meet client redemption requests but will have less leeway to do so. This liquidity risk is complicated by the fact that the historical provider of liquidity in underlying cash bonds — the investment bank acting as the dealer — has neither the balance sheet nor the risk-taking willingness to absorb such a wave of selling in the current regulatory regime.
The big question is whether other investors — including alternative vehicles, hedge funds and perhaps even sovereign wealth funds, central banks or companies with large cash balances — could step in to close that gap.