What prolonged illiquidity means for credit markets

Plenty has been written about quantitative tightening and its effect on duration and yield curves. Less has been said about what a more hawkish monetary policy will mean for credit market liquidity, a dynamic which could have profound effects.

Liquidity worsens in the medium term
As the ECB is likely to wind up its asset-purchase programme this year and the Federal Reserve gradually brings its balance sheet back towards normal levels, pressure is mounting on credit markets which have become accustomed to highly accommodative central bank policies over the last decade. Developments on this front, combined with fears of a US–China trade war and the forthcoming budget announcement in Italy, have resulted in investors taking an increasingly cautious stance, making it costlier and more difficult to exit large bond positions in the cash market.

When liquidity is reduced, bid/ask spreads tend to widen and it becomes harder to exit positions when volatility spikes. This dangerous feedback loop between liquidity and volatility can have serious consequences for market dynamics, with the exacerbated BTP sell-off in May a case in point. For fund strategies which are macro-driven like our own, being invested in liquid assets is a key characteristic that allows one to respond quickly and cost-effectively to changes in the outlook. Any delay or costs to trading herein would prevent the investment process from being top-down driven and fully adaptive to the ever changing environment.

Pockets of danger
As liquidity worsens across credit markets, investors are having to become more agile, particularly as pockets of danger become apparent. Over the past quarter in particular, there has been growing pressure on those sectors of the bond market that have benefitted most from quantitative easing and the “grab for yield” environment investors had become accustomed to. It is these pockets of the market that have suffered from outflows as sentiment has turned, manifesting itself in bond routs in local currency emerging markets and the Eurozone – especially Italy, where the spread over German Bunds widened to its largest level since 2013.

In contrast, other segments of the market, such as US High Yield, have remained more resilient during these periods given that the flow story in recent years had already been less supportive, with positions therefore largely cleansed.

Efficient workarounds
In this environment, it has become critical to be able to respond very quickly to market dynamics and new developments, which more liquid instruments such as CDS indices and fixed-income futures have allowed us to do.

Some derivatives, such as CDS indices and fixed-income futures, have a number of qualities which allow themselves to be an appropriate alternative to bonds. Their most important attribute is their ability to gain exposure with far greater liquidity, but these instruments also allow one to exit a position more quickly, with lower costs and in larger volumes.

This is particularly important when looking to manage risk more actively, and with a top-down rather than bottom-up approach to fixed-income investment.

Additionally, CDS indices have the added benefit of actually seeing liquidity increase during periods of market stress, while they can also offer relative value opportunities compared with cash bonds. This makes them particularly attractive at the moment given that the investment grade bond market has benefited from significant quantitative easing inflows, which squeezed cash bond prices and are now at risk of reversing as QE is unwound.

As such, and given the backdrop described, we have been increasing our credit exposure to CDS indices gradually throughout this year across our funds to take advantage of this liquidity premium, while reducing our exposure to the cash bond market.

Liquidity in focus
Central bank support for financial markets has clearly peaked as they look to normalise both rates and balance sheets while growth is still robust. As such and with volatility in financial markets slowly rising, optimising portfolios with regards to liquidity is set to become a more crucial component of portfolio construction.

Mohammed Kazmi, portfolio manager, Macro Strategist, Union Bancaire Privée (UBP)

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