The looming bond crunch

Since the financial crisis, banks have offloaded their bonds to funds. If bonds slip up, and the funds can’t sell, this will be dangerous for ordinary investors. Simon Wilson reports.

What’s happened?

A rout in government debt markets last week has intensified fears among analysts and investors over a lack of liquidity in asset markets, particularly bonds. Specifically, there have been several warnings that if a big sell-off in corporate and high-yield bonds arrives – perhaps triggered by the start of US monetary tightening – then bond markets could experience serious liquidity problems. In other words, bonds would become hard to sell at almost any price, potentially exposing private investors to huge losses.

Already, trading bonds is far harder than it used to be, warns market veteran Norval Loftus, chief investment officer at Allegra Asset Management. “It’s like night and day compared with six or seven years ago,”, he told The Daily Telegraph. In fact, “it’s even tougher than it was six or seven months ago”.

Why is that?

Since the 2008 crisis, new rules governing investment banks have reduced their ability – and desire – to act as de facto market makers for bonds. Unlike shares, bonds are not traded on highly liquid public exchanges; instead, they are sold “over-the-counter” between two parties. So for a liquid market to be created – one where investors can buy and sell quickly without moving the price drastically – it helps if there are institutions, such as broker-dealer banks, that are able and willing to hold (“warehouse”) huge inventories of bonds, enabling them easily to match buyers and sellers.

That used to be the case, but now it isn’t. Banks – for reasons of cost – have slashed bond inventories, reducing their ability to smooth out price swings in times of stress. According to asset manager CQS, the stock of bonds held by broker-dealer banks has fallen from $300bn in 2008 to just $50bn. This is despite the fact that the overall stock of bonds has soared. For example, the level of outstanding US high-grade corporate debt has risen from $2,800bn in 2008 to $5,000bn now. Yet market turnover, according to Barclays, is “at or close to the lowest levels on record”.

Who owns these bonds?

Many of them are owned by mutual funds – which is what makes this whole issue so potentially dangerous for ordinary investors, who have piled into bonds with unprecedented enthusiasm. According to US Federal Reserve data, US investment funds used to hold about three times as many bonds as banks did. Now they hold 20 times as many – another factor that reduces the ability of banks to make markets. This all amplifies the risk to investors in bonds – which is a particular problem because this is an asset class whose chief attraction (at least when it comes to bonds with higher credit ratings) has traditionally been its perceived safety.

The results of this imbalance, according to some analysts, are events such as the bond market “flash crash” last year, when the yields on Treasuries (US government debt) tumbled by 0.34 percentage points for no apparent reason. Although it might not sound like much (and in this case came as investors rushed to buy – driving yields down – rather than to sell), this was a significant move in perhaps the most important financial markets in the world. The incident was described by The Economist as “an extraordinary shift for the bedrock security of the global financial system”.

What is being done about it?

The big risk bond markets face is what would happen if lots of investors wanted to sell at once. Mutual funds typically return investors’ funds on demand (“daily liquidity” in the jargon). But if rates rise, and investors rush out en masse, bonds might become untradeable except at rock-bottom prices, as was the case for subprime assets in 2008.

Gillian Tett in the FT notes that some central bank heads “privately admit that if a really big crisis were to hit, central banks could eventually be forced to make markets themselves”. Equally, entrepreneurial brokers (such as Mint Partners) have set up new trading platforms to provide alternatives to the banks and allow asset managers to exchange assets with one another directly.

So all will be well?

These kinds of entrepreneurial response are encouraging, says Tett, but “it is unclear whether they will be enough to avoid future jolts, given the sheer scale of the structural mismatches”. One issue is that matching buy and sell orders is trickier for bonds than for shares. Firms may only have one or two classes of shares, but dozens of bonds, in different currencies and with different maturities.

So while there have been several attempts to set up platforms, none has attracted much volume, says The Economist. This “may mean asset managers are forced to offload securities at fire-sale prices in times of turmoil”. That’s bad news for investors.

What should investors do?

We’d be wary of bonds in general – they are very expensive compared to history. When looking at your own portfolio, be aware that many funds are able to restrict redemptions by investors if liquidity problems arise, says Brian Dennehy of fundexpert.co.uk. So review your portfolio. If you aim to sell the fund within the next five years, be comfortable that you will be able to do so. Invest in bonds of shorter maturities: their value is less affected by interest-rate moves.

Strategic bond funds have proved popular this year, as their flexible mandate should help reduce risk, but some, especially larger funds, could still be vulnerable to liquidity issues, according to Darius McDermott of Chelsea Financial Services.