(Corrects third to last paragraph; MarketAxess did not buy the Aladdin platform from BlackRock but entered into a partnership)
* Regulators scrutinise impact of poor bond liquidity
* Calls for enhanced risk disclosures for mutual funds
* Buyside adapt to waning bank risk appetite
By Christopher Whittall
LONDON, March 10 (IFR) - Asset managers are revolutionising their approach to bond trading to counter growing fears over their ability to keep pace with redemptions in the event of a sudden pullback from fixed income. The move comes as regulators are scrutinising the precarious liquidity mismatch of mutual funds invested in increasingly illiquid corporate bond markets while offering investors daily liquidity.
Liquidity has drained from secondary credit markets in lock-step with dealer bond inventories cratering from a peak of US$235bn in 2007 to a mere US$37bn now. Over this time, mutual funds - most of which offer daily liquidity to investors - have mushroomed to US$840bn, according to Citigroup, on the back of a glut of global debt issuance.
Bond fund supremos are loath to admit that fixed-income funds should no longer provide daily liquidity for fear of the asset class losing its lustre in the eyes of investors, and many are adapting their operations in an attempt to preserve the status quo.
But the inability of capital-constrained dealers to buffer the flows once the sun sets on the 30-year fixed-income bull market has raised the grim prospect of asset managers resorting to gating supposedly open-end bond funds during bouts of extreme volatility.
“It never was appropriate for corporate bond funds to offer daily liquidity, and it’s now more inappropriate than ever given the size of mutual funds and the inability of the Street to warehouse risk,” said Matt King, head of credit strategy at Citigroup.
“We are in favour of efforts to improve liquidity, but it’s doubtful they’ll make much of a difference. Bonds are not equities - they really need a warehouse.”
Questions remain over what would happen if fund redemptions outpaced managers’ ability to liquidate bond holdings and return cash to investors. Global regulators including the Bank of England, the US Treasury and the Federal Reserve are all understood to be monitoring the issue.
One credit market veteran said that if the liquidity wasn’t there, an open-end fund would become a closed-end fund. “It would be unpleasant and unfortunate, but it’s the harsh reality of life,” he said.
Policymakers may yet insist on greater disclosure of fund liquidity risk rather than relying on investors to read the small print. For their part, asset managers are adapting behind the scenes to the new trading environment.
“Everyone is painfully aware of the liquidity challenge and portfolio managers are modifying their strategies accordingly,” said Richie Prager, global head of trading and liquidity strategies at BlackRock.
Larger asset managers stand accused of leaning on syndicate desks to secure meaty bond allocations to avoid having to buy their fill in pricey secondary markets. Some now only buy bonds they are comfortable holding to maturity, while others squirrel away a disproportionate amount of cash to handle redemptions, creating a natural drag on performance.
Many firms have also transformed trading desks to act as internal market-makers between their own funds - one firm estimated as much as a quarter of its bond flows were now executed in this way - while others have established capital markets groups to source assets directly.
“As clients demand daily liquidity, and within the context of investment banks decreasing the availability of risk capital, buyside trading is now an incredibly important aspect of investment management. It has a far greater impact on fund liquidity and performance than ever before,” said Stephen Grady, global head of trading at Legal and General Investment Management.
Managers who had prided themselves on appearing plain-vanilla in the aftermath of the financial crisis are now finding themselves increasingly drawn to the liquid and standardised credit default swap market to shift risk.
“If you’re selling daily liquidity funds, you have a duty of care to optimise the liquidity of those assets. That includes looking at other ways of accessing liquidity such as using CDS,” said Fraser Lundie, co-head of investment manager Hermes Credit.
While bond investors concede there is no single solution to the industry’s liquidity problems, there are a number of initiatives that might help, such as buyside-to-buyside trading platforms, adapting trading protocols and encouraging companies to standardise debt issuance schedules.
Some of these efforts have foundered. Last year, MarketAxess partnered up with BlackRock, taking over the electronic trading and broker dealer operation for the asset manager’s struggling Aladdin bond trading platform, while Goldman Sachs recently shuttered its G-Sessions offering. Practitioners say even successful platforms will only help at the margin, and are unlikely to be open for business during a genuine market meltdown.
Meanwhile, the issuer’s paradise created by lax monetary policy means there is little economic incentive for companies to standardise issuance programmes. There is, though, too much at stake for asset managers to give up the fight, meaning something will have to give eventually.
“Everyone’s behaviour is changing, which will eventually lead to a new market structure where liquidity is less of a challenge. The evolution is not going to happen overnight, but we’re making progress on virtually every front,” said Prager. (Reporting By Christopher Whittall, editing by Matthew Davies)