“When the markets get stressed, the liquidity is just not there,” one dealer tells Euromoney in an in-depth report on the infrastructure of the global fixed income markets.
Although Fed chairman Ben Bernanke’s decision last week to delay tapering of bond purchases caused the market to rally, dealers warn that when rates begin to rise, investors might find their rush to the exit blocked by the inherent lack of liquidity in the market.
Elie El Hayek, head of government bond trading at HSBC, warns: “The old business model is being destroyed and there’s nothing to replace it yet. There are days when the credit market barely exists and the government markets are getting more like credit. You might have to sit on off-the-run treasuries for days at a time before unwinding a position taken down from a customer.
“We may have to endure some very serious problems in markets when rates really start to go up before there’s a solution to all this.”
Other dealers say the liquidity problems in the market, both in the June correction and more generally, have been overstated. They say it was the super-abundance of liquidity in the run-up to the credit crisis five years ago, when banks funded at close to zero cost, that was the true anomaly.
Liquidity has often been patchy in bond markets, especially credit markets with the proliferation of tens of thousands of individual issues, each with distinct maturity dates, terms, conditions and even covenants, many of modest size.
Zoeb Sachee, Citi’s head of European government bond trading, agrees with his competitors from across Canary Wharf. “When markets go up and down a lot, people often draw from that the conclusion that they are less liquid, but markets can move violently without there being a structural flaw,” he says.
“What most concerned me during the sell-off in June was not so much illiquidity as the fact that it seems so many in the market have come to regard extraordinary low rates and quantitative easing as permanent features of the investment landscape.
“June’s volatility was not about a reduction in liquidity; rather it was central banks reminding investors that certain long strategies had become over-positioned.”
Sachee says the European markets are more able to cope with shocks than would have been the case two years ago. “Markets may have become more fragmented and localized, but also less vulnerable,” he says. “We’ve seen much more two-way flow in recent months.”
However, what will happen if rising rates lead to a broad bond market sell-off?
Biswarup Chatterjee, head of e-trading at Citi in New York, is still hopeful that the market will set new clearing prices efficiently. “If there are sustained redemptions from bond funds and no ready or immediate buyers, then first dealer inventory will build up,” he says. “Dealers will then seek to hedge exposure by selling bonds or using other market instruments.
“Bond prices may cheapen up to the point that relative-value buyers come in to buy, such as hedge funds that might have greater flexibility of deciding when to buy since they are not subject to daily redemptions.”
Chatterjee suggests that dealer reluctance to take on inventory now is partly based on a simple judgment that bonds are just too expensive.
“Dealers and their shareholders expect a minimum return on capital or balance sheet used, and to the extent greater returns become achievable, dealers will deploy more capital,” he says.
“And the experience with sustained sell-offs such as in European sovereign bonds a couple of years ago is that the exit doors for bond sellers will open a little wider and dealers will take on more inventory because investors may be willing to pay a spread to get out.”
However, regulation is discouraging banks from holding risk and pushing them to a balance-sheet-light model. And the full impact of regulation has not yet been seen, according to El Hayek.
“This is probably going to get worse because a lot of rules, such as the leverage ratio, have still to be enacted and these will hit trading books and accrual books alike, and will pull more liquidity from government bonds and swaps,” he says.
“Even in government bonds where there are two-way flows, rarely do buyers appear for the same instruments at the precise moment when other investors want to sell and that’s why someone has to warehouse the basis risk. But if dealers cannot now step in as the buffer, no one else can.”
Investors believe rules over compensation could also have an adverse effect on bank desks’ willingness to trade.
“What happens in Europe when new pay limits come in capping bonuses as a proportion of base salary?” asks one. “Banks tell us that they are rewarding traders for turning over their books more efficiently.
“But if a bank trader has hit his budget six months into the year and knows he cannot earn any more money and can only lose, then it becomes economically rational for him to stop trading.”
