Fixed income investors must take action to protect themselves from stresses in bond markets as the squeeze on liquidity continues to plague the sector, says Kames Capital’s Adrian Hull.
Despite the huge sums of money pumped into markets over the last seven years, fixed income continues to face a threat from a lack of liquidity.
With banks effectively forced to sell down securities they owned after funding them became almost impossible, and regulators across the world still making it less attractive for them to hold traded securities, this key part of the market has been forced to scale back lending significantly.
At the same time the quantitative easing programmes of central banks have helped to stretch valuations on many bonds, leaving them more vulnerable to corrections.
Hull, a senior fixed income product specialist at Kames, says: “Dealers within banks have reduced their inventories of bonds, which makes it harder for investors to trade larger positions, while a coincidental search for yield has driven more investors towards bonds.
“In many cases this has led investors into exchange traded funds, which are particularly vulnerable to periods of market stress, and indeed the Bank of England and Financial Conduct Authority are sufficiently concerned that they have announced their intention to examine bond market liquidity in some detail.”
Hull said the situation is coming to a head now with potential rate rises making it more likely fixed income may see increased selling pressure from investors. Such an event would test the true level of liquidity in markets, and as such, he said managing this risk should be seen as a key challenge.
So how can investors prepare their portfolios for the worst? Hull has identified four steps Kames’ fixed income team is taking to navigate the current environment.
Liquidity should be central to any investment process
There is little to be gained from investing time and resources on researching issuers and bonds if these ideas are not sufficiently liquid to implement.
Liquidity needs to be considered at an early stage in the research process, and investors should never buy a bond without having a clear exit strategy. In practice, our managers and central dealing team monitor liquidity in the market using multiple market venues. We also maintain direct and transparent relationships with the underlying counterparties to ensure effective execution of trades on platforms.
We have also greatly expanded our counterparty list over the last five years as banks have retrenched and refocused, and we remain agnostic as to where we deal.
Be disciplined about capacity management
There is a risk that funds which attract large amounts of assets may be forced to compromise investment strategies to maintain liquidity.
We undertake detailed capacity analysis to understand the optimum size of any investment strategy. If any of our funds became large enough to create liquidity concerns, we would stop accepting new business.
Indeed, in early 2015 we restricted inflows from new investors into one of our absolute return bond funds to mitigate the potential impact of additional assets on liquidity and performance, protecting the interests of existing investors.
Marking-to-market ensures transparency on pricing
During periods of market stress, such as in 2008 and 2009, many fund managers were forced to offload the bonds they could sell, rather than those they wanted to. In some cases this was driven by managers not being prepared to realise losses. This can lead to higher-quality, more liquid investments being sold, leaving remaining investors holding less liquid assets with unrealistic valuations.
A fund manager’s pricing policy is an integral part of the effective management of liquidity. We believe it is essential that a bond fund’s assets are marked-to-market rather than accepting index prices. Only by doing so can stated net asset values reflect genuine trading prices that can actually be achieved.
Ensure independent oversight of risk
In addition to managing it on a day-to-day basis, liquidity is among the key risks monitored by our independent risk team. We conduct regular liquidity studies of our portfolios and examine liquidity factors within our risk and control meetings. Our chief investment officer also oversees liquidity in our clients’ portfolios, with any concerns escalated to executive board level.