LONDON, Feb 16 (Reuters) - A collapse in day-to-day trading in emerging bonds is forcing fund managers to increasingly rely on buy-and-hold investment strategies, with more and more of them unable to sell securities when they most need to do so.
There is a disconnect between booming new issue markets and the moribund secondary trade picture. This may even worsen if near-zero or negative Western bond yields bring more entrants into emerging markets where, according to BNP Paribas, the average stock of a dollar bond trades less than twice a year - down from 4-5 times back in 2007.
Emerging debt, like Western junk-rated corporate bonds, is a casualty of a liquidity crunch caused by tighter bank regulation after the 2008 crisis. Default rates are still low but many fear a turn in sentiment that forces funds to rush for the exits, only to find it doesn’t exist.
“My advice is: don’t delude yourself you can buy something then find a liquidity window to get rid of it because that may not happen,” said Greg Saichin, head of emerging debt at Allianz Global Investors. “Something you think is a tactical investment may turn out to be a permanent position.”
A reminder of this danger came last month when talk of a default by Belarus caused a stampede to dump its dollar bonds. Like many such esoteric issues, Belarus’ debt, after its primary launch, is rarely traded in the secondary market.
“The market has become so thin I would say liquidity is afforded only to the first mover, especially when we are talking about small issues such as Belarus,” said another fund manager, who struggled to sell his holdings after the default scare.
A few years ago, a selection of banks would have been around to take the bonds off his hands.
But these market makers, who facilitated trading by holding securities on their own books and displaying bids and offers, have all but vanished as new regulations made it costly for them to hold riskier assets on their balance sheets.
As a result, securities holdings - or inventories held to trade with - have declined by two-thirds at European banks since 2007, the Bank of International Settlements estimated last November. Separately, corporate bond inventories at U.S. primary dealer banks are down more than 70 percent in this time, according to New York Federal Reserve.
Data specifically on emerging debt inventories is harder to come by, but it is fair to assume the fall has been at least of a similar magnitude if not greater.
So how bad is liquidity? The best gauge is possibly the turnover ratio - total trading volume of a bond over a year versus the amount outstanding. The ratio on emerging corporate bonds last year was below 1.0, versus 3.5 before 2008, the above graphic, based on BNP Paribas data, shows.
The slump has coincided meanwhile with a capital raising rush from junk-rated U.S. “high-yield” firms as well as “frontier” sovereigns such as Kenya or Guatemala. The most explosive growth came in emerging corporate debt which has $2 trillion outstanding, a 20-fold increase since 2000.
“We (banks) do not have the capacity to warehouse such volumes,” Kathleen Middlemiss, credit strategist at UBS, told a recent conference organised by emerging debt trading and industry body EMTA. “The losers will be high-yield bonds.”
With banks on the back foot, asset managers have become the main bond market players, prompting watchdogs such as the BIS to warn they could suffer most from any future debt blowout.
Waves of central bank money printing - with the euro zone kicking off full-fledged bond-buying next month - have sent hordes of new, cash-flush fund managers to emerging markets.
But this has manifested itself largely in primary markets where new bonds, even from weak names with little or no borrowing track record, have been enthusiastically received.
So enormous is this tidal wave, that of the $750 billion in emerging corporate debt listed on the CEMBI index, only a tenth is now held by dedicated EM funds, the EMTA conference heard.
Electronic trading could be one solution, at least for smaller deals - e-trading platform MarketAxess says secondary EM debt volumes rose 18 percent between 2013-2014.
Emerging market banks too may step up as alternative market makers, said the BIS study which found inventories growing at Asian and Latin American banks.
But Allianz’s Saichin says that for now there is only one realistic strategy to counter risks of a market seizure.
“What to do with good entities you took on when liquidity was plenty and... all of a sudden the market doesn’t allow you to move them around?,” he said. “The answer is: if you want to invest, buy something you will want to hold for a long time.” (Reporting by Sujata Rao; Editing by Toby Chopra)