Brexit: the bond trader’s unlikely friend

By: Michael Turner    

The immediate reaction to the UK’s game-changing vote on June 23 was nothing short of pandemonium. Markets plummeted, with UK bank and house building stocks tumbling by more than 30%, while UK banks’ additional tier-1 bonds – the riskiest type of debt in a bank’s capital structure – plunged by up to eight percentage points.

“This vote is extremely damaging to the UK economy,” says Marino Valensise, head of multi-asset and income at Baring Asset Management.

But a tiny island of calm has emerged from the maelstrom. Bond market liquidity – the absence of which has long been the bogeyman of traders and investors – has been on the rise since the referendum result, as market participants try to work out what might be coming next.

“People have to take a stance on what they feel the outcome may be,” says one credit trader at a Japanese bank. “I don’t know how this is going to turn out, and neither does anyone else, so there is going to be a lot more two-way trading.”

This allows investors to dump positions that aren’t working and buy into bonds that look set to soar far more easily than earlier in the year.

The exact definition of liquidity in the bond market is fuzzy, but one general idea that investors and traders agree on is that it is strongly linked to how easy it is to buy or sell assets without moving their price. Another point on which market participants agree is that liquidity breeds more liquidity: investors are comfortable trading more frequently because they know they will be able to get in and out of positions quickly and cheaply.

This is far from the normal state of affairs. In the second quarter of this year, it was not uncommon for investors in the volatile high yield and emerging markets to pay 2 basis points to sell bonds, only for the market to turn, leaving them struggling to find increasingly expensive paper for sale. When they eventually found a seller, they would have to cough up another 2bp to buy back in. On a $5 million clip, that’s a $2,000 change of mind.

“When markets are illiquid, sometimes it’s best to just do nothing, even if you’re holding a losing hand,” says one emerging market investor.

Marino Valensise, Baring Asset Management

Of course, no one is saying that Brexit is exclusively good news for bond secondary markets, as uncertainty naturally brings with it the problem of volatility. But even this worry can be watered down with improved liquidity. The pervasive agreement across fixed income trading desks at banks and investment houses is that while post-Brexit volatility has been tough, illiquidity brings with it a far worse type of market capriciousness – one instigated by the herd. Investors have long demonised this type of volatility, and it’s easy to see why. If the market turns against their positions, they can find themselves stuck as their holdings move further and further into the red.

This highlights one of the biggest ironies facing investors – that good sentiment is not always a positive. Any large agreement among investors and traders – good or bad – will cause liquidity to dry up as a herd mentality takes over and almost everyone rushes for the same paper. Those that don’t blindly follow the herd can lose out big.

And there is always the chance that sustained volatility will not become the new normal in a post-Brexit vote world. Already the UK political scene has calmed slightly, soothing markets with it, with the sooner-than-expected appointment of Theresa May as prime minister.

Besides, much of the perceived volatility in markets is actually non-realised, claim proponents of one hopeful school of thought that is made up exclusively of investors. Instead, it is an illusion created by market makers book-marking assets at the levels they want to trade at, rather than the level a sale and purchase would actually take place through an online trading platform.

But many investors say that while liquidity has increased since the referendum, there is still a low cap firmly above how liquid the market can become.

The blame for this, they say, falls squarely on the banks that have moved away from their liquidity-providing broker-dealer roles and toward much less balance sheet-intensive agency-dealer positions.

“Every bank is becoming an agency dealer,” moaned one high-yield investor. 

And even those investors that don’t have a gripe with banks have to admit that the improved liquidity highlights a big flaw when it comes to bonds: that one of the supposedly more stable financial markets benefits from cataclysmic financial events.

This has yet to prompt much navel gazing among the bond buying fraternity, mainly because introspection is best left for less interesting times. But some investors say that it’s nothing more than another sticking plaster that would have been unthinkable just a few years ago.

Considering the same could be said for the unprecedented asset purchase programmes of central banks around the world and the negative rates that have followed, it is hard to see where the sticking plasters end and the structure of a healthy bond market begins.