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Asset managers' worries over bond market illiquidity swell with market's growth


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Asset managers' worries over bond market illiquidity swell with market's growth

The absence of liquidity in fixed-income markets could pose a growing threat to investors, two asset management executives said.

Fixed-income trading has become an increasingly difficult task in recent years with trading activity drying up in certain asset classes, most notably in the corporate bond space. With hundreds of thousands of bonds outstanding, traders often struggle to pin down counterparties that can buy or sell the illiquid assets.

Retail and institutional investors, as a result, may end up enduring the worst of that illiquidity, especially in times of heightened market volatility when buying and selling those assets becomes that much more vital.

"[Liquidity is] like oxygen," Calamos Investments LLC co-Chief Investment Officer Matt Freund said in an interview. "When it's there, you don't think about it very much. When it's not there, things start dying in a hurry."

The fixed-income markets keep growing in size as well, further stretching the already limited amount of available liquidity. In 2017, more than $900 billion in U.S. corporate bond issuances took place, a stark jump from the nearly $700 billion in U.S. corporate bond issuances that occurred five years earlier, according to S&P Global Market Intelligence data.

The depressed liquidity in the corporate bond market has been tied to a handful of market factors ranging from regulatory reforms to the way bonds trade.

Large dealers in the fixed-income space, including big banks, used to be able to hold onto bonds issued by companies with the intention of selling them later to investors. But reform measures implemented after the financial crisis, such as the Volcker rule, limited banks' abilities to hold potentially risky assets, including bonds, for extended periods on their balance sheets.

Bonds also trade in a market environment still dominated by personal trades. While equities made the transition to an electronic-driven marketplace more than a decade ago, players in the fixed-income arena have struggled to make a similar move as the bond market's size and fragmentation makes it difficult to centralize liquidity on specific venues.

In 2017, about 20% of all corporate bond trading volume came from electronic-trading platforms like those owned by MarketAxess Holdings Inc., TradeWeb LLC and Bloomberg LP, according to research and consulting company Greenwich Associates. That marks nearly double the volume of corporate bonds that traded electronically in 2007, but is still only a fraction of the overall market.

Instead, most bonds trade over the phone and through chat messages and emails. That structure makes off-loading large amounts of corporate bonds a chore for asset managers and investors, who typically have to break up larger orders, Calamos' Freund said.

"You just don't have the plumbing to handle massive moves," said Freund, who previously worked as chief investment officer of USAA Investments. "If you're day-trading illiquid or hard-to-mark securities, there's a chance that if you want to sell on Tuesday, you're not going to be able to."

In an attempt to find an alternative vehicle to trade fixed-income assets, Freund has been actively exploring interval funds, which may not completely eliminate the risks of holding a corporate bond but could mitigate some of the volatility usually seen in such an asset, he said.

An interval fund offers shareholders a periodic chance to sell back some of their shares to the company introducing the fund itself, creating a source of liquidity for shareholders. The fund may also provide a solution to the lack of transparency in the corporate bond market, where fragmentation and illiquidity makes price discovery difficult, Freund said.

These trading conditions for corporate bonds have existed for years, but investment managers are still encouraging investors to diversify their holdings with fixed-income assets. That trend has been exacerbated with the migration to passive investment strategies through vehicles such as exchange-traded funds that follow market indexes and certain sectors, said Tom Stringfellow, president and chief investment officer of active management company Frost Investment Advisors LLC.

Frost Investment Advisors has found a sizable business in the fixed-income realm, with its Frost Total Return Bond Fund climbing in 10 years from more than $200 million to about $2.7 billion in assets, he said. While their fees may be considerably larger than their passively focused peers, active managers can provide investors with strategies designed to avoid illiquid assets, Stringfellow said.

"Most people still think of fixed income as that safe, where-to-go place for interest income," he said in an interview. "As rates go up, that safety becomes more of a ripple and tidal [wave], but hopefully not a tsunami."