Fixed income: Preparing to change

As global regulators press on with reforms such as Basel III, John Bakie investigates what the new world of bond trading will eventually look like.

The liquidity crisis in fixed income has been one of the top issues affecting the buy-side this year and looks set to be a dominant issue for some time to come as the sell-side and vendors look to supply solutions.

A recent speech by the Bank of England’s Minouche Shafik, deputy governor of markets & banking, suggested that many liquidity issues faced by bond markets are permanent and market participants should get used to holding their fixed income investments for longer.

Speaking at the at the AQR Asset Management Institute in October, Shafik said: “Taken collectively, the response of regulators, banks and individuals to the financial crisis is recognition of the fact that – with the benefit of hindsight – the over-extension of banks’ balance sheets in the provision of liquidity before the crisis was ultimately unsustainable.”

The fairly rapid withdrawal of banks from market making in fixed income, largely as a result of balance sheet provisions in Basel III, has impacted the ability of the buy-side to find liquidity in corporate bonds.

Some of these trade so rarely that it can be almost impossible to find a match with another buy-side firm over any reasonable timescale.

Philippe Guillot, executive director of the markets directorate at French regulator the AMF, agreed with Shafik’s assessment, saying the role of banks in fixed income, coupled with a persistent low interest rate environment, has distorted the market.

He says: “The buy-side is not being realistic about the liquidity profile of these assets. If you go to your retail bank and you buy a two-year bond that pays 4% and after a year you want to redeem it, then you might only get 2% back.

“You were being paid an illiquidity premium to hold it for two years and you accept that you lose that premium if you redeem it early and you should expect the same thing in corporate bonds as well.”

Of course, a market maker will make its money by eating into that illiquidity premium, but market makers benefit from economies of scale to give better prices. Getting a similarly good price in a buy-side to buy-side trade may be more challenging.

Guillot adds that the nature of fixed income is fundamentally different from the equities market, and attempts to use an equity-like trading model in bonds may be destined to failure.

“Equities can go up and down, and you’ll almost always be able to find someone taking an opposite view to you and be able to trade,” explains Guillot, “…but in fixed income it can only go in one direction so it’s much harder to find someone who wants to buy when you need to sell, and as such you have to take a hit to find the liquidity you need.”

Solid liquidity

If the new reality is that fixed income assets will become far more illiquid than before and that new platforms coming onto the market cannot fully plug the gap left behind by the reduction in bank inventories, what should the buy-side do about it?

Shafik said market participants need to review the way they think about illiquid investments: “When making the decision to purchase an asset they should ensure that their investment horizon is aligned with the inherent liquidity of that asset. And they also need to understand that abundant market liquidity in normal times may not be indicative of the ease with which they can exit a position or effectively hedge it in times of stress. When it comes to matters of market liquidity, the old adage ‘caveat emptor’ or ‘let the buyer beware’ still applies.

The issue was raised at a recent buy-side boardroom discussion hosted by The TRADE in London and traders present agreed with Guillot and Shafik’s sentiments, but said the regulatory environment does not fully reflect this problem.

Guianluca Minieri, global head of trading at Pioneer Investments, said: “I agree that fixed income isn’t meant to be a liquid asset class, but I think regulators need to look at their own rules which force UCITS funds to offer daily liquidity.”

It seems the buy-side is being artificially constrained by regulatory rules that might outwardly appear to benefit end investors but can actually cause distortions in the market that could result in poor trading outcomes.

Minieri added: “I think what would be useful for asset managers is if we could implement longer redemption periods that reflect the natural liquidity of the underlying, giving weekly or monthly liquidity depending on the liquidity profile of the bonds in the fund.”

Traditional behaviour

End investors can tend to act irrationally in times of market stress, which in turn puts pressure on asset managers to act in a similar way and can be disastrous in less liquid asset classes.

This has been seen before in the real estate market, where in 2007/08 as the financial crisis began to bite, several real estate funds had to suspend redemptions because it was simply not possible to rapidly offload entire buildings from a portfolio.

However, these funds came under intense pressure over the inability of investors to get out, yet to have any chance of meeting these redemptions would require a firesale, resulting in significant losses for investors. It’s easy to see a similar situation arising in the corporate bond market, if panic suddenly gripped investors.

However, there may be options for buy-siders that already exist within the regulatory structure of UCITS funds.

Richard Phillipson, principal at investment management consultancy Investit, said UCITS funds do allow for fortnightly valuations, though it is currently underutilised.

“UCITS allows you to do your valuations twice a month instead of daily and this could help to cope with the inherent illiquidity of fixed income assets,” he said.

“However it seems the industry does need to move towards a model of providing more permanent capital.”

“It could also offer a significant first move advantage for any fund that switches to using fortnightly valuations as they should, in theory, be able to obtain better prices and better returns,” Phillipson added, “I’d like to see one of the big asset managers try it with one of their funds to see if it proves a workable solution.”

Platform view

But what does this all mean for the glut of secondary market platform providers that have hit the market over the past two years?

Anecdotal evidence suggests some platforms are receiving a positive reception from the buy-side, but these represent just a handful of more than 50. The first major casualty was seen earlier this year when Deutsche Boerse-backed Bondcube was shut down. A lack of buy-side liquidity meant it had failed to gain any traction in the market.

At The TRADE’s buy-side boardroom, the cost of connectivity was highlighted as one of the main issues preventing the widespread adoption of new all-to-all trading facilities.

While one project, Neptune, is now up and running with the aim to standardise network connectivity for fixed income trading, it is not yet fully developed and has more services and functionality to be added.

It also seems that being able to offer something different, rather than trying to simply function like an exchange for fixed income, is something the buy-side is looking for.

Platforms that have received particular praise include Liquidnet and Algomi, and it is telling that both are heavily focused on issues of information leakage.

One buy-sider told The TRADE: “Systems that spam out requests for quotes (RFQs) to an ever wider array of market participants are not helpful, it just gives away your intentions to too many parties.”

However, Guillot says the entire concept of bond trading platforms may be unworkable; “Trying to organise a secondary market in something that is inherently hard to resell may not be the optimal solution for this market.”

It seems there are no easy answers to the Bond market’s current woes. While the buy-side can be relatively certain that banks and market makers will never return to the bond market in the same capacity as they once did, there is far less certainty over the best path to obtain the liquidity they need.

The best approach will likely consist of a mix of relying on what little liquidity broker dealers can bring to the market, new trading platforms and, perhaps, lobbying for a change in UCITS liquidity rules.