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Credit: When the well goes dry

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As market markers retreat, Joseph Mariathasan notes that bond portfolio managers are holding more cash, using more derivatives, focusing on primary issues – and preparing for liquidity to get even drier

Capital markets thrive on liquidity. Institutional buyers and sellers of securities looking to trade in blocks of tens of millions of euros require either many potential counterparties on the opposite side, or market makers holding inventory in large sizes. The former can be fragile, especially in a time of market stress. But since the financial crash of 2008-09 an environment of increased capital requirements for banks has also had a major impact on the size of market makers’ trading books.

“Capital charges for holding inventory are three times higher, post-crash, for most investment banks,” notes Garrett Walsh, head of credit research in Europe at Pioneer Investments. “The inventory of cash bonds on dealers’ books has fallen dramatically. In the US, holdings of primary-dealer investment-grade bonds have fallen by 75% and we don’t see that changing anytime soon.”

Indeed, the trend even preceded the crash.

“Liquidity has been an issue for some time,” insists Owen Murfin, a portfolio manager at BlackRock. “The Lehman crisis accelerated the de-leveraging of the financial sector, but there have also been previous shocks, such as in the late 1990s, when the bank’s balance sheets and commitment to secondary trading in investment grade bonds also shrank.
There are now just a handful of securities that trade quite frequently and more securities that don’t trade at all, or just trade once a month as market markers focus on a few liquid lines of stock.”

And this is all before the effects of any enacted financial transaction tax come into play, which Mark Benstead, head of credit in the UK at AXA Investment Managers, fears could push bid/offer spreads out by 20 basis points, reduce cash market liquidity by 15% and derivative-market liquidity by three-quarters. Most practitioners would agree when he says:
“The changes to liquidity are structural, not cyclical. The good old days won’t be back.”

In the good old days, active managers would typically turn their portfolios over two or three times a year. Today they might reach 100%. That has changed the way funds are managed – particularly bigger funds.

“When yields are this low, the cost of turnover becomes very important. When the bid/offer spread is one point, if you trade 75% of your portfolio you will need to make a lot of extra performance to get that back,” says Benstead.

Holding sufficient cash for portfolio management can be a major consideration, now.

“We certainly make sure we hold a much higher cash balance than we may have done in the past,” says Walsh. “We have over 10% cash in the fund at the moment and we always make sure we have 5-10% cash. When the market was fully liquid, we might have had 1-2%.”

Shift to derivatives
One effect of reduced liquidity in the cash markets has been a shift to derivatives. The liquidity in index products such as iTraxx has been good, with traders able to deal up to $500m a day. “Single-name CDS contracts are less liquid, with perhaps $20m being traded in Telecom Italia or France Telecom before moving the market becomes an issue,” says Murfin.

At Pioneer Investments, the investment process for both absolute return and index-benchmarked strategies is based on derivative overlays.

“We don’t have many individual bond positions and we try and implement pretty much
all our strategies using derivatives,” says portfolio manager Vianney Hocquet. “We use single-name CDS and we indices to take directional bets and we are going to trade CDS options, which are among the most liquid instruments available.”

But as he admits, even in the derivative markets, liquidity has dried up quite a bit, thanks to uncertainties over new regulations on CDS.

The second major change in investment strategy has been the greatly increased significance of the primary market as a tool for active management. This takes out the bid/offer spread, of course, and usually also comes with some extra spread for taking primary-market risk.

“If you want to get meaningful exposure to a name such as BMW the most efficient way to do that at a good price is through the primary market,” says Walsh. “That is something we are spending a lot more time on now than in the past.”

For investment banks, the primary market is much more attractive: whereas in the past they would have inventoried issues that they had brought to market for a much longer period, today making markets in a few on-the-run issues is generally seen as the price they need to pay to win primary mandates.

This all means that fund managers have to devote more attention to the syndication process.

“We make sure we have very good relationships with the investment bank syndicate desks and try and get involved in the syndication process as much as we can,” says Walsh.
“Very often we are asked for feedback on deal structure, pricing the credit profile of companies, and so on. By engaging in that process relatively early we hope to ensure our position in the allocation process.”

Tricky and delicate process
But as Benstead points out, in highly sought-after issues, managers may still receive as little as 10% of the amount they ask for. Large and long-standing clients may be favoured with 14-15%. It is a tricky and delicate process to get right. Inflate your order to make sure you come close to the allocation you want and the suspicion in the market grows that you might be a “flipper” – an investor who locks in that primary-market premium by immediately selling a new issue to another market maker.

“I used to work on a syndicate desk and you could see who was inflating their order – they were the last ones in the book because they put in only after they got a feel for market demand,” says Benstead.

Not surprisingly, many managers are proud of having a clear policy of not inflating their requirements to maintain their credibility with syndicate desks.

While there is little doubt that the changing liquidity landscape has forced portfolio managers to adapt, there remains the question of how much worse the situation might get – and whether it presents investors with a significant risk of sudden capital loss.

“Retail holdings of corporate bonds have probably tripled over the past five years and if yields start to normalise those retail investors may be faced with capital losses, particularly in bond funds that have a constant duration that has lengthened over the past two years,” says Benstead. “They may find themselves 10% down at a time when equity markets are booming. Retail disenchantment with bonds could be really nasty as there is no way that the market-makers are set up to absorb that volume.”

Benstead likes to cite a favourite statistic: in 2007, if mutual fund holders had reduced their holdings by 5%, dealer inventory would have only had to increase by 10% – not a problem. Now, because corporate bond holdings have exploded and inventory is constrained, if retail investors reduced holdings by 5%, dealer inventory would have to double. “That just is not going to happen,” he warns.

In that situation, the fear is that bid/offer spreads would widen dramatically until the marginal buyer of last resort – institutional funds – stepped in. That would be a great buying opportunity, but of course the process of getting there will be anything but smooth. Bond investors may have to hang on tight over the coming months – and enjoy the ride if they can.

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