Changes to Bond Markets Create Liquidity Concerns and Systemic Issues Bond Investors Should Consider

Portfolio Manager Perspectives

Key Takeaways:

  • A systematic decline in liquidity could make price swings more severe
  • Banks and underwriters are less willing to smooth out volatility during periods of dislocation
  • Record bond issuance and investors stretching for yield may accentuate volatility in this environment

A Recent Report from the Office of Financial Research Suggests Systemic Causes May Accentuate Market Vulnerability

The third annual report from the Office of Financial Research, a newly created division of the Treasury Department as a result of the 2010 Dodd-Frank Law, warned that bond markets are vulnerable to more shocks due to new regulations that have changed trading patterns. The full report can be found at this link.

According to the Office of Financial Research's report, "Markets have become more brittle because liquidity may be less available in a downturn. Recent volatility in financial markets focused attention on some of the vulnerabilities that have been growing over the past several years".

The Office expressed concern that market participants such as banks and securities dealers may be less willing to enter the markets during periods of dislocation to facilitate trading that can smooth volatility, an important role these institutions have played in the past. In order to meet the requirements of Dodd Frank, banks have had to increase their capital footings and curtail risk-taking activities. As a result, many financial institutions have made significant reductions to their bond trading departments over the last several years in terms of personnel and capital allocations. While banks and securities dealers are now more insulated from certain market risks, these risks have shifted to investors.

In addition, the report noted that high-volume trading driven by algorithms and automatic computer programs can deepen volatility and potential market instability. In other words, risk today is more likely to be tilted toward institutional and individual investors and away from banks and dealers.

The Unwinding of the Fed's Unprecendeted Accommodative Posture Has an Unkown Impact

The Treasury's massive bond buying effort known as Quantitative Easing came to an end late last year. With the Fed recently unwinding this program, the market impact is yet to be determined.

Furthermore, while the Fed remains in a very accomodative mode, expectations of a likely shift in policy in the future are also causing uncertainty.

Expanded Corporate Credit and Investors Stretching for Yield

Just as investors stretched for yield, record bond issuance rapidly expanded corporate credit. But bond trading has actually shrunk by 7.4% in 2014 according to the Securities Industry & Financial Markets Associations.* A sudden or rapid rise in interest rates could make these markets more volatile as bonds decline in value and face an exodus of investors.

As the Fed held yields close to zero, investors have poured money into lower quality credits and less liquid or infrequently traded bonds. As a result, many investors are more exposed today to credits with higher risk profiles. The market for speculative grade securities has grown 83 percent since the end of 2008.* At the same time, Wall Street banks reduced their role of making markets in these bonds and supporting these markets with liquidity during periods of volatility. The Office of Financial Research Report also sites this as a potential source of volatility.

Volatility could be accentuated, particularly in higher return/higher risk sectors such as high yield bonds or bank loans. As Fed policies change and flows subside or recede, the likelihood of an orderly exit from market upheaval is lower.

Suggested Strategies

  1. Investors should assess their portfolios to make sure they aren't exposed to hidden pockets of risk or that portfolios aren't too far tilted toward more risky exposure
  2. Maintain adequate diversification
  3. Maintain a core portfolio of bonds in high quality, more liquid securities

Important Disclosure Information 

The suggested alternative strategies may help protect principal in a volatile environment. There are risks involved with this strategy including, but not limited to, changes in interest rates, liquidity, credit quality, volatility and duration.

Investments in mortgage and asset-backed securities include interest rate, prepayment, extenstion and default risks. Investments in non-investment grade debt securities include risks such as increased credit risk and higher risk of default or bankruptcy.

Diversification does not ensure against loss and does not guarantee a profit. Past performance is not a guarantee of future results.

Robert W. Baird & Co. Member SIPC. 

*"What's Worse: Big Banks or Exposed Bondholers Shaking Markets," Bloomberg, 12/3/14