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Alliance Bernstein On Risk Parity And The Bond Liquidity Crunch-And What To Do About It

Playing With Fire: The Bond Liquidity Crunch-And What To Do About It by AllianceBernstein

When investors ask if an asset is liquid, what they usually want to know is: will they be able to get rid of it quickly, either to realize a profit or avoid a loss? But liquidity isn’t constant. It depends on many factors, from investor sentiment and behavior to market structure and conditions. And over the last few years, changes in all of these elements have combined to drain liquidity from the global bond market.

Stricter regulations have prompted banks to reduce their role as active buyers and sellers of corporate bonds. Central banks’ easy money policies have driven government bond yields to record lows and pushed investors to crowd into the same risky trades. And large institutional investors are increasingly relying on risk-management strategies that use leverage and may cause investors to act the same way at the same time. This increases the risk of correlated moves across assets.

On their own, none of these trends is likely to trigger a major market crisis. But taken together, they’re creating a lot of dry tinder. And the next shock to hit markets might be the spark that sets everything ablaze. With fixed-income volatility rising, investors can’t afford to take this risk lightly.

Fortunately, there are ways to manage liquidity risk. Investors that do it well may even find bargains, especially if they have large balance sheets and long investment horizons. In this research, we examine what investors can do to protect their portfolios. We also look at what they should expect of their asset managers. After all, managers who don’t see the big picture with liquidity probably won’t be able to keep their clients out of the liquidity trap.

Correlated Sell-Offs Becoming More Common

Trading Days When Us Stock And Bond Returns Were Both Negative

Bond Liquidity Crunch Sell-Offs

The Liquidity Crunch And What To Do About It

Professional bond investors tend to be a gloomy bunch. Even at the best of times, they can rattle off at least half a dozen things to worry about. But if you ask what’s keeping them awake at night now, you’re likely to get just one answer: liquidity.

What’s draining liquidity from the market? Most investors blame changes in global regulations. New rules designed to make banks safer have also made them less willing to take risks. As a result, they aren’t big buyers and sellers of corporate bonds anymore. This has made it harder for investors to trade large blocks of bonds-and it’s making them worried that they may have to take big losses if they need to sell assets in a hurry.

Bond Liquidity Crunch

Bond Liquidity Crunch

We agree that low liquidity is a risk-but by focusing on regulations, we think most investors are underestimating the gravity of that risk. While new regulations have contributed to the problem, there are several less obvious causes that have the potential to make the liquidity crunch worse.

Some stem from global central bank policies (see “Central Bank Liquidity,”): easy money has driven government bond yields to record lows and forced yield-hungry small investors to crowd into the same trades. Another driver is caution by large institutional investors, who are less and less willing to take the long view in bonds and ride out short-term market volatility.

While regulatory changes have reduced the supply of liquidity, these trends have drastically increased the potential demand for it. None on its own is likely to trigger a major market crisis. But taken together, they’re creating a lot of dry tinder. And the next shock to hit markets-that prompts everyone to sell-might be the spark that sets everything ablaze. With volatility in fixed-income markets rising, investors can’t afford to take this risk lightly.

Fortunately, there are ways to manage liquidity risk. Investors that do a good job of it may even find bargains in less liquid markets-especially if they have the luxury of large balance sheets and long investment horizons. In this paper, we will examine what investors can do to protect their portfolios. We’ll also look at what they should expect of their asset managers. After all, managers who don’t see the big picture when it comes to liquidity probably won’t be able to keep their clients from getting snared in a liquidity trap.

But first, let’s take a closer look at what we believe is draining liquidity from the system.

Regulation: Wall Street Retreats

Anyone who buys and sells bonds for a living has noticed that it’s harder than it used to be. That’s not because the global bond market is shrinking. In fact, it’s growing. Companies have been on a borrowing binge, thanks to record-low interest rates. And investors are still lining up to buy new corporate debt.

The problems start after new bonds are issued. Over the past few years, investors have found it tougher to trade large blocks of bonds without significantly affecting their prices. To put it another way, trading on the secondary market, where bonds change hands after they’ve been issued, hasn’t kept pace with overall market growth (Display 1).

This is where those stricter banking regulations come in. In the past, banks held vast inventories of corporate bonds and traded them regularly, making a profit for themselves and making a market for other investors. This kept price fluctuations in check and was especially valuable in times of stress, as investors could count on the banks to play the part of willing buyer when everyone else wanted to sell.

Bond Liquidity Crunch

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