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Illiquidity concerns increase over ‘missing party’ in fixed income markets

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Asset managers have warned against increasing illiquidity in fixed income markets amid concerns institutional allocations are causing scarcity of assets and price bubbles.

Several well-documented factors have forced European pension funds into higher-yielding fixed income assets, with some sovereign bond yields at all-time lows.

Sub-investment-grade corporate debt has increased in popularity, including the use of sovereign debt from lower-rated European countries.

Pension funds have shifted vast amounts of assets into these areas, with demand for assets now hampering future supply.

Pascal Blanque, CIO and deputy chief executive at French asset manager Amundi, recently told IPE he would “accept any phone calls” regarding the availability of corporate debt.

And Mike Karpik, chief executive at State Street Global Advisers (SSgA), said recent conversations with institutional clients showed a focus around tail-risks and acknowledging that valuations had moved into the top deciles, with markets feeling “bubbly”.

“There are all these pockets of euphoria,” he said. “Yields are down in high yield, while Italian bonds are down to a level people did not think we would see.”

Karpik highlighted investors with SSgA were questioning illiquidity risk increasingly.

He added that, given the change in the regulatory landscape and the “retreat of opposite parties”, bid-offers had widened.

“I worry about the amount of liquidity, particularly in corporate debt and structured products,” he said.

The rush of capital into the fixed income markets in previous is easily highlighted by the dramatic fall in yields in recent years.

Data sourced by Bloomberg and Merrill Lynch, and provided by M&G Investments, showed average European investment-grade yields falling from 2.7% over three years to 1.97% over one year.

Similarly, European high-yield average coupons fell from 7.16% to 4.85%.

The retreat of investment banks and primary dealers, which provided liquidity during the global financial crisis, could have a significant impact should asset values begin to fall and institutional investors start a run.

Figures from AllianceBernstein showed that, by the end of March 2013, when the Federal Reserve Bank of New York discontinued its data monitoring, primary dealer holdings of corporate debt had fallen by almost 75% since mid-2007 to $58bn (€42bn).

However, alongside this, corporate bond markets had grown by 62% over the same period to $5.8trn.

Karpik said: “I worry, in the next crisis, when you need players and two sides to create liquidity, the other side won’t be there. The last one saw a lot of people and participants, but now it is substantially less.”

Despite the rise in issuance in fixed income products, demand for these assets from pension funds is still causing concern.

Andreas Koester, head of tactical asset allocation at UBS Global Investment Management, said managers were facing capacity constraints, particularly since investment banks were no longer “warehousing” trades.

He also warned investors that derivatives would not save them from issues of illiquidity in fixed income markets, essentially because enough investors were using these products for the same issues to occur.

“Investors need to stop thinking they are five minutes smarter than everyone else,” he said.

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