Fidelity s View on Bond-Market Liquidity

Fidelity s View on Bond-Market Liquidity Alexander Marx l Head of Global Bond Trading Michael Connolly l Global Head of Leverage Finance Trading KEY TAKEAWAYS The market structure for fixed-income trading has evolved since the financial crisis, and this evolution has implications for liquidity, especially in stressed or challenging market environments. A security s liquidity, which fund managers assess when making investment decisions, is a measure of its potential to trade in the market, and it is one of the key attributes reflected in a security s price. Active bond-fund managers can enhance long-term returns by opportunistically buying undervalued assets during periods of liquidity stress. Bond-fund shareholders can exacerbate liquidity costs by redeeming their shares during periods of market stress. Recent media reports have warned that fixed-income investors should be wary of bond-market liquidity. Some have even suggested that fixed-income markets could be the source of the next financial crisis. In this paper, we look beyond the barrage of media warnings and put forth an objective framework for thinking about bond-market liquidity, with a focus on: the evolution of fixed-income trading since the financial crisis a working definition of bond liquidity Fidelity s approach to managing liquidity in bond funds, and considerations for bond mutual fund shareholders Evolution of fixed-income trading Unlike stocks, which typically trade on an exchange, with buyers and sellers matched electronically, fixed-income securities trade primarily over the counter. In this structure, a principal or an intermediary (typically broker/dealer firms) facilitates trades by purchasing bonds from sellers and holding these bonds on their balance sheets until buyers can be found. Providing this service requires work and risk taking (i.e., owning bonds on balance sheet), and it therefore comes at a premium (price). This premium is paid to the intermediary from the bid-offer spread the difference between the price at which an intermediary is willing to buy a bond (bid) and the price at which the intermediary is willing to sell the bond (offer). The bid-offer spread is dynamic and is a function of market conditions and transaction amounts. Because of regulatory changes and a reduction in risk taking at broker-dealer firms, the market structure for buying and selling bonds has evolved over the past several years (see

Leadership Series article: Bond Market: Resetting Expectations in a Post-QE World, Nov. 2014). As a result, the fixed-income market now has fewer intermediaries, and those who remain are less active in the markets (see Exhibit 1). What s more, intermediaries today are often acting in the capacity of an agent rather than a principal matching buyers and sellers without taking an ownership position in the security. In some instances, buyers and sellers trade directly with each other, bypassing intermediaries. This evolving intermediary structure can influence the ability to transact in a security, and can affect its price, as well as contribute to bond-market volatility in stressed or challenged markets. What does liquidity mean? Before drawing conclusions about liquidity in a market or for a security, we think shareholders need to understand what can be meant by the term liquidity, recognizing that the term can be used to mean different things. It may be useful to think about the liquidity of a particular asset as the potential to sell or purchase some amount within a reasonable period of time without significantly affecting its price. Clearly, the amount sold and the length of time taken to sell a security can affect an asset s price (see How trade size and timing can influence pricing, page 3). However, the liquidity of an asset also depends critically on the asset type and its structural characteristics. At Fidelity, we think about the liquidity of fixed-income assets along a continuum. At one end of the liquidity spectrum are highly liquid U.S. Treasury securities, and at the other end are relatively less liquid private-placement securities, which might require legal paperwork to transfer ownership. It is useful to contemplate liquidity on a continuum because of the variety of bonds with varying characteristics that make up the $39 trillion 1 fixed-income market (see Fixed income is not a single market or asset class, page 4). The fixed-income market consists of a diversity of sectors, issuers, and buyers, and is constantly adjusting and reflecting changing capital market conditions. 1 Source: The Securities Industry and Financial Markets Association (SIFMA), as of Jun. 2015. High-yield assets estimated based on index data. See Index definitions, page 6. Exhibit 1 Consolidation among large financial institutions has resulted in fewer bond-market intermediaries and has changed their role. SELLERS INTERMEDIARIES BUYERS Traditional Structure PRINCIPAL AGENCY Evolving Structure PRINCIPAL AGENCY For illustrative purposes only. Source: Fidelity Investments. 2

FIDELITY S VIEW ON BOND MARKET LIQUIDITY How trade size and timing can influence pricing Consider an asset owner who wishes to sell a large quantity within a short period. Traditionally, the sale would likely be negotiated with an intermediary acting as principal. In this case, all the risk associated with holding the asset would be transferred from the original owner to the intermediary, who would then conduct a search for willing buyers and simultaneously attempt to offset or hedge the assumed balance-sheet risk. The intermediary would likely require compensation for bearing this risk, and therefore could pay a lower price than it would pay if purchasing much smaller amounts of the asset over a longer period of time or if given time to locate a different buyer in advance, facilitating an agency transaction so that the asset would not be owned by the intermediary. In both principal and agency transactions, the intermediary is compensated through the security s bid-offer spread. Different types of securities have different core attributes, which in turn influence their buying and selling activity. Structural attributes that influence the liquidity of these security types most frequently include: Trading volume. As the size and frequency of transactions in an asset increase, uncertainty about the asset s current fair market value is reduced, and intermediaries are therefore more willing to facilitate trading in the asset. For example, Treasury securities trade in very large quantities many times each day, making the prices of these securities highly transparent. Private placements may not have traded since they were first issued, requiring price expectations to be extrapolated from similar securities that traded more recently. Amount outstanding. The total face value of securities outstanding will influence the number of owners of the security, and thus the size of the potential base of buyers and sellers. A larger pool of potential buyers and sellers can reduce balance sheet risk for an intermediary, because less time and effort is required to find willing buyers. With approximately $13 trillion of debt outstanding, the Treasury market is the largest single sector in the overall fixedincome market, and is many orders of magnitude larger than all private placements collectively. Regulatory treatment of dealer balance sheets. Regulations enacted since the financial crisis have imposed stricter capital requirements on dealers for holding and/or hedging asset types deemed to be riskier than Treasury securities. These new capital requirements have therefore created incentives for intermediaries to facilitate trading in Treasury securities, and to hold these securities on balance sheets, rather than more capital-intensive assets such as private placements. Investors should recognize that these factors all contribute to asset liquidity on a given day, and influence Fidelity s fixed-income portfolio managers investment decision making. Fidelity s approach to managing liquidity in bond funds Traders At Fidelity, our investment teams are continually monitoring market conditions to assess whether prices include a fair reflection of expected transaction difficulty. Teams of professional traders with a long history of transacting in a variety of economic cycles and market conditions monitor liquidity continually with the help of state-of-the-art riskmodeling tools. Because of the complexities of the fixedincome market, Fidelity has organized its experienced traders into teams dedicated to each sector of the bond market (e.g., governments, mortgages, corporates, structured). Our traders directive is to translate data and market behaviors into investment insights that portfolio managers can use as they implement investment decisions. The traders provide critical intelligence about liquidity, valuation, and technical conditions in the marketplace. They engage with Fidelity s research analysts to ensure that investment recommendations reflect market developments within their specific sectors, including current prices, relative value, new-issue activity, specific security availability, and secondary market trading activity. With such breadth of trading knowledge, Fidelity s traders can provide assessments of bonds being transacted across the quality spectrum. This has proven to be an advantage to performance when issuers of securities have moved from the high-yield universe to the investment-grade universe, and vice versa. 3

As a large fixed-income manager with a long history of trading in all varieties of markets, Fidelity has developed strong relationships with intermediaries across bond sectors. Portfolio managers Taking a broader, portfolio-wide view, Fidelity portfolio managers make investment decisions that are consistent with a fund s investment objective, and implement strategies with a multiyear perspective. The determination of a portfolio strategy always considers security liquidity. Each portfolio manager, considering the input of credit analysts and traders, evaluates a large number of potential investments. Managers combine these investments in such a way as to balance income, capital appreciation potential, and price volatility. Liquidity risk has always been present in the securities markets. Like other risks, investors should be aware that investing in less-liquid securities those with larger bid-offer spreads can be a source of both positive and negative portfolio return. Temporary liquidity stress that results in a bond being priced below its estimated fundamental value can be an opportunity for active fund managers to enhance a fund s longterm returns. On the other hand, larger bid-offer spreads for less-liquid securities can detract from realized returns if securities must be sold in stressed liquidity conditions. Fixed income is not a single market or asset class The investment-grade bond market can be divided into five sectors, ranging in size from $1.4 trillion to $12.6 trillion. In addition, the high-yield bond market, made up of four sectors, represents another $4.1 trillion in the market (see Exhibit A). Distinct bond features such as issuance size, quality, coupon, years-to-maturity, industry sector, and options characterize each sector and affect the bonds trading properties. Additionally, bond issuers are a diverse group that includes U.S. federal, state, and local governments, as well as domestic and global corporations and banks. Just as there are many different types of issuers offering bonds in the market, there are various types of bond buyers, including individuals, mutual funds, pension funds, corporations (including insurance companies), and governments, each with different goals driving their investment preferences. At any time, the ebb and flow of capital, or fluctuations in bond prices, can reflect many things, including supply-and-demand conditions, economic outlook, valuations, and perception of risk. Exhibit A Bond-market composition (figures in trillions) Investment Grade Sectors High Yield Sectors Rates/Treasuries $12.7 Emerging Markets $1.6 Local Currency $0.9 Hard Currency $0.7 Structured $1.4 TOTAL ASSETS $35.2 $10.7 Agencies/Mtgs High Income $1.3 TOTAL ASSETS $4.1 $0.8 Leveraged Loans Municipal $3.7 $6.7 Corporate Real Estate Debt $0.4 Source: Investment-grade data from SIFMA, U.S. Bond Market Issuance & Outstanding, as of Jun. 30, 2015. SIFMA corporate data adjusted to represent investment-grade debt only. High-yield assets based on the following indexes: Emerging-market debt JPMorgan EMBI Index. Leveraged loans S&P LSTA Loan Index. High-yield bonds BofA Merrill Lynch U.S. High Yield Index. See Index definitions, page 6. 4

FIDELITY S VIEW ON BOND MARKET LIQUIDITY With regard to overall fund liquidity, portfolio managers regularly consider historical shareholder redemption patterns. Recognizing that there is an opportunity cost for not being fully invested, cash holdings are generally only one component of a portfolio manager s liquidity sourcing strategy to meet shareholder redemptions. Considerations for bond mutual fund shareholders Though a bond fund s shares can typically be converted quickly to cash, the need for a fund to sell securities to meet redemptions can affect the prices that a fund receives when selling securities, and therefore may affect realized proceeds. Consider the hypothetical example of many bond fund shareholders, acting independently, who assume bond prices will decline, perhaps worried about rising interest rates. Suppose that these investors redeem shares and thereby require the fund manager to sell securities from the underlying fund. If the transaction amount is sufficiently large, the sale price could be lower than expected because the intermediary must perform a more extensive search for buyers or perhaps assume greater balance-sheet risk by keeping the securities in inventory, which can contribute to a lower bid price. Because the realized price was lower than expected the transaction could affect the fund net asset value (NAV), and thus the amount of realized proceeds for the redeeming shareholders and the value of the shares held by the shareholders remaining in the fund. In an alternative scenario, consider shareholders in this same bond fund with a longer-term focus who choose not to redeem their shares. Assuming the liquidity cost adjustment is temporary, these shareholders would experience nothing more than short-term mark-tomarket NAV volatility without long-term impact on the returns they realize. Markets are notoriously difficult to time profitably, because security prices adjust to reflect investor consensus views. Even before considering market valuation, professional forecasters have consistently been too bearish and have on average predicted higher rates that have not then occurred. For these reasons, investors are usually best served when they continually reflect on their multiyear financial plans and make sure their investment objectives are aligned with their holdings. Summary When weighing the recent warnings about bond-market liquidity, there are several points to consider. First, liquidity can mean different things to different investors. In our view, it is the potential to sell or purchase some amount of a fixed-income asset within a reasonable period of time without a significant impact on its price. Secondly, the size and diversity of the fixed-income market makes it difficult to focus on security liquidity with only one lens. The varieties of security types in this market have different core attributes that influence trading potential. Attributes that can frequently influence liquidity include trading volume, amount outstanding, and regulatory treatment of dealer balance sheets. Lastly, price fluctuations, regularly observed in fixed-income market sectors, are natural phenomena of the capital markets and are carefully weighed by Fidelity s portfolio managers as part of their investment decision making. Shareholder reactions to volatile markets should be guided by their established multiyear plan that includes investments with the appropriate risk-and-return characteristics to help them achieve their objectives. AUTHORS Alexander Marx l Head of Global Bond Trading Alexander Marx is head of global bond trading in the fixed-income division at Fidelity Investments. In this role, he is responsible for overseeing global fixed-income, cash, and derivatives trading. Michael A. Connolly l Global Head of Leverage Finance Trading Michael A. Connolly is global head of leverage finance trading in the high-yield division of Fidelity Investments. In this role, he is responsible for overseeing global high-yield, leveraged-loan, and emerging-markets debt trading. Fidelity Thought Leadership Vice President Geri Sheehan, CFA, provided editorial direction for this article. 5

2015 FMR LLC. All rights reserved. 732797.1.0 Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. In general the bond market is volatile, and fixed-income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed-income securities carry inflation, credit, and default risks for both issuers and counterparties. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indices are unmanaged. You cannot invest directly in an index. Index definitions JPMorgan EMBI Global Index is an index of U.S. dollar-denominated debt instruments issued by emerging-market sovereign and quasi-sovereign entities, such as Brady bonds, loans, and eurobonds. S&P LSTA (Loan Syndication Trade Association) Loan Index reflects the market-valueweighted performance of U.S. dollar-denominated institutional leveraged loans. BofA Merrill Lynch U.S. High Yield Index is a market-capitalizationweighted index of U.S. dollar-denominated, below-investment-grade corporate debt publicly issued in the U.S. domestic market. Barclays U.S. CMBS Index measures performance of the market of commercial mortgage-backed securities deals with a minimum current deal size of $300 million. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. If receiving this piece through your relationship with Fidelity Financial Advisor Solutions (FFAS), this publication is provided to investment professionals, plan sponsors, institutional investors, and individual investors by Fidelity Investments Institutional Services Company, Inc. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI), Fidelity Family Office Services (FFOS), or Fidelity Institutional Wealth Services (IWS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with National Financial or Fidelity Capital Markets, this publication is for institutional investor use only. Clearing and custody services are provided through National Financial Services LLC, Member NYSE, SIPC. 6