If investors learned one lesson from the Lehman Brothers debacle, it was that correlations converge in a bear market. In 2008/09 even “safer” bonds fell prey to selling pressures as beleaguered investors failed to provide a bid for panicked sellers trying to become liquid. Essentially, either you had cash or you didn’t —and if you didn’t, you wanted it.
Fast forward to today: Yield-hungry investors have poured money into liquid structures containing less liquid assets. For example, exchange-traded funds (ETFs) promise daily liquidity, even if they own high-yield bonds or leveraged loans that can prove difficult to sell at times, especially in a bear market. Investors need to realize that return and liquidity are inextricably related. As one seeks higher returns by pushing out the risk spectrum, liquidity is often sacrificed.
Why is liquidity something to worry about? Because after the Lehman experience, a renewed effort to rein in risk taking resulted in a multitude of government regulations intended to lessen the chances that another systemically important financial institution would ever fail. As a result, bank balance sheets are now constrained, proprietary trading activities are prohibited and overall market-making activity is no longer supported by large amounts of capital. Ironically, the end result is that bond markets may have become more illiquid and more volatile.
Despite a huge amount of new bond issuance since 2007, average daily trading volumes have shrunk dramatically. Secondary trading activity is choppy and inconsistent in most bond markets, including the U.S. Treasury market. This is likely due to the shrinkage of U.S. Treasury dealers from eight in 2007 to four today.
Here are the differences from the end of 2007 (pre-crisis) to the end of 2014 per the Securities Industry and Financial Markets Association (SIFMA) and the Bank for International Settlements (BIS) data.
Per the table above, total trading volume has dropped approximately 19% since the pre-crisis year of 2007. The only reason volumes have not shrunk in the investment-grade corporate space is that mega-size, new primary issues have created an opportunity for money managers to flip bonds post-issuance, very similar to the IPO marketplace for equities
The BMO Multi-Asset Solutions Team understands that market risk comes in multiple forms and liquidity risk is generally misunderstood or often ignored. While our economic and market outlook leads us to continue holding allocations to potentially less liquid high-yield bonds and leveraged loans in the majority of our strategies, we also maintain a healthy dosage of higher-quality shorter-term securities and cash to help mitigate any potential liquidity concerns across portfolios.