How asset managers are adapting to fragile bond liquidity

By Simon Doyle | December 15, 2016 | Last updated on December 15, 2016
3 min read

The BoC says liquidity in the corporate bond market remains fragile as portfolio managers use new trading tactics to reduce risks.

The central bank, in its report Thursday analyzing risks to the Canadian financial system, identified fragile corporate bond liquidity as a key vulnerability, along with household indebtedness and elevated housing prices relative to incomes.

In response to bond liquidity risks, fixed income managers have “fundamentally altered” their trading, the BoC says, as regulatory reforms have helped to reduce the risks that dealers take on their balance sheets.

Important bond dealers such as banks, for instance, have shifted from principal trading to agency trading, where they match clients directly with corporate bond buying and selling without temporarily bringing the securities onto their balance sheets.

Asset managers have also adapted by holding more recently issued securities and increasing their investment horizon for assets with liquidity issues. They are making trades less frequently and dividing big orders into smaller, multiple trades, the BoC says.

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Prab Sagoo, associate director at Nasdaq Advisory Services, tells that corporate bond liquidity has become more of an issue amid higher underlying volatility, brought on in part by automatic trading programs and other quantitative models.

“I think it’s very much understandable and feasible that these asset managers, the banks and all the trading desks want to take some of the risk off their books,” says Sagoo.

The BoC says some securities dealers are also using ETFs to source corporate bonds and help manage inventories. The central bank suggests there is a risk, however, that if ETFs “and other asset managers were required to sell large quantities of fixed-income assets to meet redemptions, this could put stress on market liquidity.”

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Some dealers are even seeking returns on the liquidity shortages, the BoC says: “Some of the most active buy-side market participants are also taking advantage of the new environment by supplying liquidity (offering to transact bonds that others have a strong need to buy or sell) when this can generate a substantial return.”

The BoC cited its survey of 200 firms on fixed income during the summer. It found general concerns about bond liquidity during periods of market stress and bigger worries about liquidity in the corporate bond market.

While the corporate bond market has withstood big stress events, such as the U.S. election and the Brexit vote, “it is difficult to ascertain how well this evolving market structure will withstand unpredictable and longer lasting shocks,” the BoC says.

The bank adds that it has observed no significant deterioration in the functioning of fixed income markets since its last Financial System Review, released in June.

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Sagoo says bond liquidity could become an issue if a large financial shock caused financial institutions and investors to stop lending to one another.

“The pre-crisis period may not be the best standard for comparison, because liquidity was excessive and virtually costless at that time,” BoC Governor Stephen Poloz says. He adds that he expects market players to continue to adapt within a more resilient financial system.

Simon Doyle