Perspectives. Credit market liquidity. The changing nature of market liquidity and the need for action

Transcription

1 Perspectives Credit market liquidity The changing nature of market liquidity and the need for action The topic of liquidity in the credit market has garnered significant attention over the last few years. In this Perspectives we will highlight the magnitude and profundity of the issue in order to encourage investors to take action to protect themselves from the new market liquidity regime or indeed, if possible, capitalise on the issue.

2

3 Credit market liquidity Studies and thought pieces on the topic by asset managers, investment banks, central banks, regulators and members of academia have become commonplace. 1 However, there has been an overwhelming lack of practical suggestions and action, with market participants all too willing to rely on hope, hope that the issue will go away or they will not be impacted. In our view, the magnitude and profundity of the issue is such that action is required in order for investors to protect themselves from the new market liquidity regime or indeed, if possible, capitalise on the issue. The level and nature of credit market liquidity has changed. Volatility will increase as a consequence, particularly during periods of market stress. Investors need to review the appropriateness of fund liquidity terms and the investment styles adopted by their asset managers. Credit market liquidity has deteriorated and changed Investment banks play a key role in the effective functioning of credit markets, with the majority of transactions passing through them. Fundamentally, the role of the bank is to match demand with supply. Prior to the global financial crisis, as part of their market-making activities investment banks would typically hold an inventory of credit bonds. This provided liquidity in credit markets, with the banks able to avoid the often time-consuming process of matching demand with supply. Instead, banks were able to match demand instantaneously using their inventory and would be willing to purchase bonds from customers and expand their inventory. Transaction costs (bid/offer spreads) and market volatility were lower as a consequence of the role played by banks. In the new banking regulatory regime, banks have significantly decreased their stock of credit bonds since regulators have made it much more expensive for them to hold an inventory (from a capital perspective), as Figure 1 demonstrates. The result was that in 2015, inventory in corporate bonds averaged less than one day s trading volume in corporate bonds, with inventory roughly 25% versus peak levels. The market-making operations of banks are now more like a dating agency, focussed on matching buyers and sellers (or matching up singles to extend the analogy). In our view, credit market liquidity has deteriorated as a consequence of the new regulatory regime. Some commentators note Figure 1. Inventory held by banks for market-making Inventory (m) 250, , , ,000 50,000 0 Primary dealer positions Source: MarketAxess, New York Federal Reserve that bid offer spreads have not widened since the global financial crisis. Indeed, if anything, transaction costs in credit markets appear to have reduced, suggesting an improvement in liquidity. However, this is misleading: the required compensation for banks acting as agency brokers should be lower. Also, since the global financial crisis, it has generally been a very strong environment for credit. The true test will come when credit prices are weak and investors want to sell. The true picture is that there has been a significant fall in the depth and breadth of liquidity. The nature of liquidity has changed. Market liquidity is now extremely bifurcated: larger bonds and recently issued benchmark-eligible bonds still benefit from reasonable liquidity, while a large portion of the credit market rarely trades, if at all. Even amongst the more liquid, larger bonds, it can be challenging to transact in significant size and at times of market stress Willis Towers Watson s paper, Corporate bond market liquidity constrained, but active managers can still excel, represented a prescient insight into this evolving story. 3 Credit market liquidity

4 .at a time when the demand for liquidity is (potentially) increasing More capital is now invested in credit products offering daily (or instant) access to capital. This is creating greater demand for liquidity. Investors are offered the option to redeem at a mid-price with minimal notice by exchange-traded funds (ETFs), the majority of UCITS-regulated products and US mutual funds. We also observe significant growth and increased popularity in high-frequency trading hedge funds, which make further demands on market liquidity. For the majority of credit asset classes, daily liquidity is simply inappropriate and offering it introduces big risks when fund liquidity terms are not sensibly structured. We are concerned that the supply of liquidity is no longer capable of satiating demand. This will become obvious during periods of market stress, when investors often seek to reposition. A window into a challenging future? There have been several incidents of unexpected market activity across the globe over the last three years. Prior to the recent volatility, the two worst episodes were the 2013 Taper Tantrum and the October 2014 US Treasury flash crash. These bouts of extreme market behaviour and volatility provide a valuable window into the future. The Taper Tantrum was a shortterm period of huge volatility across markets triggered when the Federal Reserve started to buy fewer assets under its scheme to rescue the world s financial markets. The impact on the high-yield bond market was particularly interesting. The US market experienced price drops of up to 5%, with no evidence to suggest this price action was linked to fundamental creditworthiness in any way. Instead, it was triggered by fairly modest redemptions by jittery investors in daily liquidity investment vehicles. The reluctance or inability of banks (or any other market participants) to rapidly absorb this selling (as they would have done pre-global financial crisis) led to prices gapping lower. The events of 15 October 2014 and the flash crash were truly extraordinary and worrying in equal measure. The 10-year on-the-run US Treasury Bond holds a special designation in the fixed-income markets. As the bellwether of the world s largest bond market, it has historically been the most liquid fixed-income security and comprises the principal assets bought during times of stress in the market. On 15 October there were periods when it was extremely difficult to buy or sell this bond. Figure 2. Historical intraday yield ranges for 10-year US Treasury Count Source: Bloomberg And this extraordinary absence of liquidity occurred seemingly without cause. Even a joint investigation by the US Treasury, Federal Reserve and other bodies struggled to identify any material catalyst. In both of the above instances, the markets in question quickly calmed after the period of elevated volatility, but that is of no comfort. Both events occurred in an environment of generally benign economic conditions and a broadly positive risk appetite amongst investors. We worry about how credit markets might behave during a period of genuine macroeconomic uncertainty, where investors asset allocations are materially changing and they are all trying to sell credit assets. How effectively will positions be transferred from sellers and how will new holders be identified? And what sort of price falls will be required to bring them together? 15 October 2014 (37 bps) willistowerswatson.com

5 What are the implications? What should I be doing? The new credit market liquidity regime requires investors to take action: Be aware that fund and liquidity terms are important Liquidity of commingled investment product, should be appropriate for the liquidity of the underlying assets where possible. Fund terms should protect the interests of long-term investors. Opting for a separate account (or fund of one ) represents a solution for larger investors and can largely shield them from the change in market liquidity. Pricing mechanisms that charge investors a fair amount equivalent to transaction costs for subscribing and redeeming (or seeking to match investors) make commingled vehicles safe for investors of all sizes. We recommend that clients review the liquidity and fund terms of all the commingled products they invest in. Indeed, we strongly believe that an evolution in commingled fund liquidity terms would serve to reduce the risks associated with the new credit market liquidity regime. Clients should therefore negotiate for better terms, or shift to products that are better structured where possible. For US mutual fund investors, the times they are a-changing, The regulator is currently reviewing the mutual fund industry with the goal of greater stability and consumer confidence. Reducing liquidityrelated risks could be achieved through greater regulation, action that we support. However, the implications could be far-reaching, impacting the level of competition and choice and, potentially, the entire bond market. Monitor cash in your commingled investment funds We expect to see commingled funds run with higher cash balances to reflect the new liquidity regime. This will create a drag on performance, which will warrant investors seeking to renegotiate investment management fees down accordingly. Budget for higher volatility and higher trading costs in your portfolio Almost all investment managers profess a willingness to act as a supplier of liquidity to replace the investment banks. In reality, this is incredibly challenging given the difficulty of forecasting these episodic periods of high volatility and constraints around expanding balance sheets in order to exploit market weakness. Review ongoing efficacy of investment styles The new market liquidity regime will have a meaningful influence on the efficacy of different investment management styles. The optimal size of a fund for a given investment approach is now likely to be smaller. Higher turnover strategies seeking to exploit small anomalies appear challenged, and we are also concerned about the validity of credit strategies employing a stop-loss discipline in an environment of generally higher volatility and where prices gap during period of stress. However, one could argue there has never been a better time for managers to effectively apply a contrarian, fundamental value-type approach. Acknowledge that the illiquidity risk premium is likely to be larger going forward and exploit this where possible We expect the illiquidity risk premium to be, on average, higher to compensate investors for the new regime. This presents an opportunity for institutional investors with a long investment horizon to be able to lock up their capital and generate higher returns. Investors should be assessing this opportunity. Be wary of solutions Some market commentators proclaim that market liquidity augmentations such as electronic trading and dark pools represent a potential solution. However, this remains a peripheral liquidity source in corporate credit markets and is far from proven as a general solution. The other hope is market standardisation as a solution to the current liquidity malaise. We remain sceptical. Yes, greater standardisation of credit markets would probably improve market efficiency and most likely greatly improve liquidity, however we see little sign of this happening and no impetus to drive this change. The unusual position of J.P. Morgan issuing one type of common equity but over 1,600 different bond issues looks set to continue. 5 Credit market liquidity

6 Further information Willis Towers Watson has drafted a series of more detailed papers on the topic of market liquidity, providing significant depth of analysis and the basis for the above insights and conclusions. Please contact your Willis Towers Watson consultant for more information, or: Chris Redmond chris.redmond@willistowerswatson.com Dan Lomelino daniel.lomelino@willistowerswatson.com 6 willistowerswatson.com

7

8 About Willis Towers Watson Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com. Willis Towers Watson 71 High Holborn London WC1V 6TP Towers Watson is represented in the UK by Towers Watson Limited. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. Disclaimer This document was prepared for general information purposes and is applicable to the UK only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part,without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. This document has been issued by Towers Watson Limited regulated by the Financial Conduct Authority: register number To unsubscribe, eu.unsubscribe@willistowerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2016 Towers Watson. All rights reserved. WTW-EU-16-ICP-1745 willistowerswatson.com