Portfolio Manager & Managing Director Christian Hoffmann discusses the factors impacting liquidity in the fixed income markets and the squeeze we see today.
Liquidity can be a mystery to the financial markets: it’s there and typically when you need it most, it’s gone. In this article we will define liquidity and look at factors that are currently impacting liquidity in the fixed income markets. Some factors, such as exchange traded funds, (ETFs) are already impacting fixed income markets, while others less so such as the Fed’s quantitative tightening stance. Why is that?
What is Liquidity?
Fixed income investors purchase bonds for the income and total return they provide. However, investors must also consider the liquidity of their fixed income holdings — that is the ability to sell them at a price at or near its fair value either to meet redemptions or monetize gains and seek out new more attractive investment opportunities.
Liquid fixed income instruments may be purchased and sold easily in the secondary market. But when an imbalance emerges between purchasers and sellers, liquidity can dry up, leaving some bonds difficult to transact. The most extreme example in recent history was March 2020 when liquidity in fixed income (as well as most financial markets) nearly evaporated until the Fed stepped in to provide a backstop in certain markets.
Figures 1 and 2: Liquidity Conditions Are Comparable to the Height of the COVID Crisis
Source: Bloomberg Intellegence
The structure of the fixed income market can lead to liquidity squeezes in certain environments. Whereas nearly all equities are traded on exchanges, most fixed income instruments are traded “over the counter” – that is, the old-fashioned way, through dealers who purchase and sell bonds for their clients, and to a lesser extent, their own accounts. Most trades take place over the phone, electronic chat tools and sometimes electronic platforms. Also, fixed income instruments come in a wide variety of characteristics and structures and trading volumes are lower than their equity counterparts, which provides a favorable environment for liquidity squeezes.
This article will explore the current state of liquidity in the fixed income market as well as its impact on investors and the opportunities presented by changing liquidity.
ETF Arbitrage Exacerbates Liquidity Squeezes
One of the primary factors behind liquidity squeezes in recent years has been the emergence and rapid growth of exchange traded funds. The interesting thing that we have seen, particularly in the summer of 2022, is that market volatility drove ETFs to become forced buyers and forced sellers – depending on specific market conditions. There are days in the fixed income market when sharp price increases compel ETFs to become buyers, and days when sharp price drops drive ETFs to become sellers. An already volatile market is then further exacerbated by the large purchase and sales orders placed by ETFs to keep up with investor demand.
It’s not only retail investor demand, but asset managers as well increasingly use fixed income ETFs as an additional liquidity tool. This results in exacerbated liquidity challenges as managers of these large asset pools can also become forced sellers. This put ETF holders in the worst position – being a seller at the worst possible times, thereby drying up underlying bond liquidity when investors need it most. The results are bad executions and bad outcomes.
But not necessarily for all investors. In bad liquidity situations, active managers who are not over-risked into market sell offs have more flexibility and can be on the opposite side of these trades, therefore providing liquidity to a market that’s clamoring for it.
Federal Regulations Deprive Banks from Holding Bond Inventory
Following the Global Financial Crisis, federal regulations and legislation were enacted that hindered the ability of the banks to hold bonds on their balance sheets. In Europe, Basel III introduced additional rules that undermined the attraction for banks to remain market makers in the secondary investment grade corporate bond and other security markets.
The reduced dealer demand for bonds stems from banks’ limited ability to take principal risk via their balance sheets. Meanwhile, in the post-GFC era, credit markets saw record issuance, as issuers took advantage of low interest rates spurred by very accommodative central bank policy. This combination of the absence of a backstop in secondary markets and massive supply growth feeds into liquidity squeezes.
Technology has been making inroads with bond trading but remains nascent and with limited capabilities. Although liquidity has improved at times, it’s still a situation of having liquidity when you don’t need it, and it disappears when you do need it, as these platforms become heavily one-sided during periods of strength and weakness. What it creates instead is an illusion of liquidity.
Quantitative Tightening: Not Having a Significant Impact
In the spring of 2022, the Fed reversed course, ending its quantitative easing policy and adopting a quantitative tightening stance aimed at reducing its enormous balance sheet built up through the QE process. The limits were originally up to $30 billion of Treasury sales, and $17.5 billion of mortgage-backed or other asset-backed security sales each month. In late summer, the Fed doubled its caps to $60 and $35 billion respectively.
While it continues to look ridiculous to have a huge balance sheet while tightening monetary conditions, they are glacially moving the balance sheet in the right direction without a significant impact – so far – on fixed income markets and liquidity. Playing with the balance sheet is a much more nebulous approach and it’s harder, not just for investors to react to, but for the Fed to apply. The idea that the Fed gets to some kind of balance sheet that looks like a pre-global financial crisis balance sheet (going back to 2008/09) isn’t likely something any of us will see in our lifetimes. The Fed does not want their balance sheet reduction efforts to have a significant impact on the economy and broad financial conditions. Raising short-term interest rates will be the primary tool the Fed uses to cap and bring down price pressures. Balance sheet reduction is a gradual, controlled runoff and should not have a meaningful impact on liquidity. That does not mean there will no impact, but rather a secondary source of liquidity worries in fixed income markets.
Liquidity Conditions Are Not Static across Markets
It is generally the case in fixed income markets that Treasuries are more liquid than investment grade credit, which, in turn, is more liquid than high yield, distressed debt or lower rated areas of the securitized marketplace. But liquidity can be nuanced. Conditions differ by time and market. At times, the high yield market is slumping, and liquidity dries up, while simultaneously structured product can be reasonably liquid. What’s important and may set active managers apart from passive strategies is taking advantage of the temporal shift in liquidity between different markets as it comes and goes, ebbs and flows.
The March 2020 COVID shock is an example of just that. Different markets broke at different times and intervals. They also healed at different times and speeds. So agile active managers were able to take advantage of opportunities between markets and timing intervals, ultimately adding value for clients. As liquidity conditions change, so should manager decision-making.
As mentioned earlier, in fixed income many trades are still negotiated the old-fashioned way: someone is selling, and buyers need to figure out how much they can extract from them. Or sellers need to calculate the right time and place to transact and find someone on the other side of the trade. This differs markedly from the equity markets as some bonds do not trade for days and even months at a time. So liquidity can vary widely boiling down to investors’ comfort with taking risk.
Fixed income liquidity also depends significantly on individual issues and issuers. Fixed income investments with rock solid fundamentals tend to create their own liquidity (demand) while fixed income securities with problems and increasing risks can find their demand dwindling over time. This point is important for investors to understand. If an investor is holding a security that the market wants, the more liquid it will be when put out for sale.
Although liquidity can be very subjective to market conditions, trading platforms, and the whims of passive vehicles such as ETFs, what fixed income liquidity boils down to is the whims of investors. Sometimes it’s there, sometimes it’s not. But active managers can take advantage of these shifts by seizing opportunities to acquire solid credits that create their own liquidity. That’s a significant advantage over herd investing in fixed income. As long-term investors, we are not as subject to the whims of the market and look at liquidity squeezes as an opportunity to purchase mispriced securities.