Their concerns are highlighted in an in-depth report on the lack of liquidity in the global bond markets, published by Euromoney.
Acting as principal position takers, bank dealers have traditionally lubricated two-way flows in the over-the-counter credit and rates markets.
However, that’s no longer the case according to Richard Prager, head of trading and liquidity strategies at Blackrock, the world’s biggest fund manager.
“There is a fundamental problem here that is still being under-reported,” he says. “The equity market is an agency market, where as investors we pay brokers a fee for execution services, but as principal our clients take the execution risk of actually filling an order. We’re used to that and we understand it.
“But in the fixed-income markets, where the proliferation of myriad individual securities makes it impractical for the buy side to take on execution risk, we do not pay an explicit fee for execution. Rather, we pay a bid-offer spread to market makers, who show prices to us and are supposed to take on the execution risk themselves as principals while giving us certainty.”
However, Prager says: “The ability of the sell side to take down risk has been greatly curtailed by regulation that has sharply reduced capital available. So we are paying a bid-offer spread, but in reality we are still taking the execution risk ourselves there as well. Now, you tell me what’s wrong with that picture.”
Fund managers say it’s a problem that’s getting worse, not better, and is making it impossible for the buy side to pursue investment strategies that require ability to access resilient liquidity, as measured by the capacity regularly to execute large-size trades on tight margins.
“Bid-offer spreads are very wide and the ability to do relative-value trades in credit that might require buying $25 million of one name and selling $25 million of another is no longer there,” says Lee Sanders, head of foreign exchange and money market execution for Axa Investment Managers’ trading and securities financing division.
“Secondary-market turnover has shrunk to a fraction of primary-market supply.”
Joshua Friedberg, head of trading for the Americas at Deutsche Asset and Wealth Management, points out: “In secondary markets where bid-offer margins have marginally stabilized, remember that overall all-in yields have come down substantially over the last several years [despite the recent spike], so transaction costs are now consuming an even bigger component of the overall spread.
“Furthermore, liquidity will likely continue to deteriorate, driven by regulatory pressure. And in stressed markets, when you really need liquidity, it is certainly not there.”
Dealer inventory in the US credit markets peaked on the eve of the credit crisis at around $250 billion at a time when US credit mutual funds held about $450 billion of bonds. By May 2013, dealer inventory had declined to roughly a quarter of that peak at under $70 billion, while the holdings of bond mutual funds and ETFs had doubled to more than $900 billion.
Competition to serve leading investors is faltering and the relationship between the buy side and the sell side is in flux.
“Discussions around liquidity typically start from the assumption that banks provide risk capital and we, as asset managers, consume it,” says Stephen Grady, head of trading at Legal & General Investment Management.
“However, anecdotally, we frequently see the opposite being the case. This is due to the fact that our supply of inventory is of sufficient scale that we’re able to supply as much liquidity to the sell side as they provide to us.”
