Protecting Yourself Against The Next Bond Liquidity Crunch
By DailyAlts Staff Anyone who lived through it knows that liquidity evaporated during the 2008-09 financial crisis. In response, the U.S. federal governments imposed a series of rules and regulations designed to make financial markets safer, but instead, they’ve contributed to even more illiquidity. What can investors do about it? That’s the question explored in Alliance Bernstein’s September 2015 white paper Playing with Fire: The Bond Liquidity Crunch and What To Do About It . Trading Turnover is Down The bond market has long been considered a safe haven during times of financial stress. Historically, well-capitalized banks have stood at the ready, willing to buy bonds – particularly investment-grade and government issues – when no other buyers were interested. But due to regulatory changes, banks are hamstrung from providing this service, and as a result, turnover in both investment-grade and high-yield bonds has plummeted since the financial crisis. Increased Correlation It’s not that demand is down: New bonds are being issued in record numbers, and investors are willing to buy. The problem is that during so-called “fire-sale” selloffs – when stocks, bonds, and commodities suffer sharp declines – bond-market liquidity is drying up, and thus sellers under duress must contend with wide bid/ask spreads and lower selling prices than they bargained for. And, as a result of the policies of the Federal Reserve and other central banks, these broad selloffs are becoming more and more common. The Impact of Central Banks In the wake of the financial crisis, when liquidity dried up, central banks began forcing down interest rates by buying government bonds and other assets, thereby expanding the money supply and flooding the markets with liquidity. Their bond buys pushed interest rates down and forced yield-minded investors into riskier assets. In addition to the U.S. Federal Reserve, the U.K.’s Bank of England, the EU’s European Central Bank, the Bank of Japan, and the People’s Bank of China have all massively expanded their balance sheets since 2009. Crowded Trades With lower rates on government bonds, stocks and other riskier assets become more attractive by comparison. While 0% interest rates may have made sense as an “emergency” policy measure, nearly ten years later, rates are still pegged near zero, but it appears things are likely to begin normalizing later this year, or in early 2016. It’s widely acknowledged that the Fed and other central banks have boosted bonds and other asset prices, so the reversal of their policies is likely to have the same effect – indeed, even the Fed’s threat of scaling back its “quantitative easing” bond-buying program in 2013 led to a “fire-sale” dubbed the Taper Tantrum. The risk in 2015 and into 2016 is that yield-starved investors have crowded into too many of the same trades, and that without banks standing on guard to buy during the next “fire-sale” selloff, there may be no takers (at reasonable prices), and thus a severe liquidity crunch. What to Do About It? So what can investors do about it? AllianceBernstein’s Head of Fixed Income Douglas Peebles and Head of Global Credit Ashish Shah, authors of the white paper, provide the following list: Diversify using a broad multi-sector strategy; Be a contrarian and avoid the crowd; Keep cash handy – and don’t neglect derivatives; Do your credit homework – and expand your investment horizon; and Consider select investments in private credit. Investors should vet asset managers as part of their “credit homework.” Peebles and Shah recommend asking managers questions to gauge their acumen, such as “To what do you attribute the decline in liquidity?” and “How has your process changed as liquidity has dried up?” In closing, the authors ask investors to remember: While the financial crisis did considerable damage to markets and investors, those who kept their cool – and who didn’t rely too much on liquidity – made a lot of money. For more information, download a pdf copy of the white paper .