?Bond Market Liquidity: Don’t Confuse Investment Risk With Systemic Risk
This article originally appeared in the Financial Times on 22 July 2015.
It is not surprising that the subject of bond market liquidity has come under increasing focus among regulators, investors and the media. While banks are now better capitalized, the combination of post-crisis capital and liquidity regulations and a lower return environment has made them less able and less inclined to function as market makers. Although bank-oriented regulation has made the system more resilient and less levered, it has also had the practical effect of reducing liquidity in markets that have historically relied on banks to support trading, such as in the corporate bond market. Without the banks playing their previous “smoothing” function in trading, certain markets have seen sharper price movements, leading to more volatility overall.
While there is consensus that liquidity in certain sectors of the bond market has changed, there is not, however, widespread agreement on the magnitude of this shift or its implications. Indeed, one prevailing, albeit extreme, view is that liquidity challenges will only worsen and invariably be the trigger of the next financial crisis with deleterious spillover effects on the real economy, which would likely warrant extraordinary government action.
At PIMCO, we have a more nuanced – and less dire – view of market conditions and their implications. From what we observe, there is liquidity across the marketplace – i.e., buyers and sellers are able to transact – but transacting in certain markets may now be more costly. This makes intuitive sense: With the advent of capital regulation, the cost of capital is now higher for banks, making banks more selective about when and at what price they are inclined to use their balance sheets to provide liquidity.
This is an important distinction from there being no market price at all, however. Indeed, the phenomenon of fluctuating asset prices reflects the ebb and flow of market conditions and is an inherent risk of investing in capital markets. In other words, liquidity risk is part of the investment risk that investors knowingly take on when they invest their assets in the capital markets to pursue their investment objectives.
It is important not to confuse investment risk with systemic risk. While price moves may be more disjointed – and prices may have to decline more significantly for a market price to be established – price declines are not the same as the system failing. The transmission mechanisms that could make price declines potentially systemic, such as leverage and counterparty exposure, do not exist to the extent they did in the lead-up to the financial crisis, due to the advent of capital-oriented banking regulation and the requirement in the U.S. to centrally clear derivatives. Practically speaking, these risks do not exist in U.S. mutual funds, which are prohibited from using significant leverage and have little, if any, uncollateralized counterparty exposure.
This is not to say the marketplace will be immune to more bouts of price volatility, especially as global central banks take the first steps toward normalizing monetary policy. In fact, looking ahead, the ability of investors to generate positive returns in markets will be predicated, in part, on their ability to actively and successfully manage liquidity risk.
Liquidity risk has always been one of the main risk factors we consider when constructing portfolios, and our portfolio liquidity management is a dynamic and iterative process that we perform on a daily (and often intraday) basis.
Further, while reduced liquidity and increased volatility have been represented as purely negative developments for investors, we take a more balanced view. Volatility can actually present attractive buying opportunities for patient, active, long-term investors.
There is no doubt that markets have changed, that the ability to transact in certain markets is more challenged and that certain regulations could be revisited to improve liquidity in specific markets. But we would encourage caution in extrapolating the potential implications – particularly the systemic implications – of a more differentiated liquidity environment, especially given the reduction in leverage across the marketplace.