Liquidity Squeeze in the Bond Market
The lead article in a recent edition of Investment Week, a trade paper I subscribe to highlighted significant liquidity issues in the bond market. Liquidity refers to the ability of traders, fund managers and investors to trade stock. It is crucial to ensure a properly functioning market whilst a liquidity crunch can cause difficulty in establishing prices which may collapse with no buyers. It could increase the time or even ability of a fund manager to meet requests for redemptions and could even cause parts of the corporate bond and gilt market to shut down and funds to close. There is a recent history of this during the credit crunch and financial crisis of 2007-2009 where the commercial property market became highly illiquid and effectively shut down. Specialist commercial property funds were forced to cease trading and investors could not sell out. Eventually as the credit crunch eased liquidity improved and these funds re-opened.
The causes of the liquidity issues in the bond market are various. Banks are reluctant to trade as they are forced to raise capital and bond issuance has fallen as companies hold cash on their balance sheets. At the same time demand for corporate bonds from investors has risen due to their perceived lower risk compared to equities and the high income they provide compared to cash. The Investment Management Association (IMA) reported that the Corporate Bond sector has been the best selling sector for 10 out of the last 12 months.
Given these market conditions corporate bond funds may be forced to hold large cash balances as a buffer to help meet redemptions whilst the Bank of England could intervene to help maintain liquidity by acting as a market maker, buying and selling corporate bonds.
So should a liquidity crunch worry investors holding corporate bond funds? Possibly. The most popular funds are mega sized investments which face trading issues in normal circumstances not just during periods of illiquidity. For example the M&G Corporate Bond fund held £6.2 bn at 29/6/12 whilst the Invesco Perpetual Corporate Bond held £5.4 bn (Source: Morningstar). Imagine the practical difficulties if the fund managers want to change the asset allocation of their portfolios and this requires selling £1 bn of bonds. Aside from the difficulty of finding buyers, dumping a large amount of stock onto the market can distort prices. In contrast a smaller fund of say £500 million is much more nimble.
Whilst I have no knowledge or expectation that “super tanker” sized funds plan to close to new investors, if they do income payments should continue as usual and redemptions may still be possible. However a large number of sellers from funds will drive prices of corporate bonds lower if the unit trust or OEIC manager does not have enough cash and has to sell stock to cover redemptions.*
If redemptions from corporate bond funds are suspended investors will need to ensure they can access cash elsewhere, highlighting the importance of keeping an emergency fund. It will also mean you will be unable to undertake tactical or strategic investment decisions for example a rotation from corporate bonds to equities. However the real concern is if panic selling drives values of bonds lower. Aside from a liquidity crunch that may cause this, it could be triggered by the bubble in the gilt market bursting.** Prices will fall and this could drag corporate bonds down as well, especially investment grade stock. That said the government and the Bank of England will employ every tactic in the book to keep gilt yields at record low levels.
So what is my advice? For long term income investors corporate bonds are excellent investments, very tax efficient within an ISA and most people would be advised to stick with their holdings. However I prefer high yield to investment grade given the former offer an attractive yield premium for the additional credit risk, low default rates and less sensitivity to interest rates. They provide equity like returns but with lower volatility. For those investing in corporate bonds for low risk growth and sitting on profits it is worth reviewing your holdings and possibly switching to alternative lower risk investments in whole or part. As usual you should seek individual independent advice.
* In contrast to OEICs and unit trusts, closed end funds such as investment trusts, which are legally structured as companies listed on a stock exchange do not have to sell underlying assets when investors sell their shares and this is a distinct advantage over open ended unit trust or OEICs. Selling drives the share price of the investment trust down but not its asset value. More on this at a later stage.
** Not everyone subscribes to the view that there is a bubble in the gilt market. Yields have been driven to historic lows and hence prices to historic highs since 2008. Many professional investors have been surprised that prices continue to defy gravity and have continued to rise. Various factors including government and Bank of England policy are supportive,such as Quantitative Easing (QE). If there is no bubble nor danger of a collapse in prices on the scale of 1994 all one can say is that at best gilts offer poor value.