Credit investors are worried about liquidity.
That’s according to a sweeping new piece from BofAML that takes the temperature of the credit market at a time when developed market central banks are attempting to rollback the post-crisis monetary policy regime.
The story here is always the same. As DM monetary policy becomes less accommodative, the onus increasingly falls on price-sensitive investors to absorb supply. That, as opposed to the price-insensitive bid from central banks. Obviously, the presence of a price-insensitive bid from a determined buyer of last resort armed with a printing press has the effect of grossly distorting the supply/demand dynamics in whatever markets that buyer is operating in. And it goes beyond that. Those distortions in turn distort other markets further down the quality ladder, as that price-insensitive bid crowds out investors, who are forced into riskier assets in order to find something that isn’t priced to perfection. Before you know it, everything is priced to perfection as everyone tries to front-run everyone else in a mad scramble for yield.
Now, that dynamic is reversing itself with ramifications that are already visible in emerging market assets and with implications that are as yet undetermined for things like € HY (to name one).
On one hand, it’s nice that central banks are finally attempting to lift the “state of exception” and allow markets to once again function as price discovery mechanisms. The problem, however, is that after a decade, no one really knows what the “fair” price for anything is. If it turns out that clearing prices for risky assets are far lower than those that have prevailed when central banks were backstopping assets further up the quality ladder, well then that could create a liquidity vacuum, which is precisely what BofAML contends credit investors are concerned about in Europe.
“Liquidity has been challenging according to the findings of our analysis, and credit investors seem to think that it will deteriorate as the buyer of last resort withdraws and they will be the only buyers left in the market”, the bank warns, in a note dated September 12.
The bank goes on to write that “with inflows drying up and possibly continuing to do so as the rates cycle between US and Europe pushes money out of the latter, liquidity will likely become more challenging.” That’s a nod to the distinct possibility that with yields on short-dated USD fixed income rising (see chart below), it makes little sense to play in Europe, especially as the ECB bid evaporates.
Liquidity concerns in credit are of course exacerbated by the post-crisis regulatory regime that has made the Street less willing to lend its balance sheet in a pinch. Have a look at the stark divergence depicted in the following visual:
Here’s BofAML elaborating:
The “buy-side” vs. “sell-side” imbalance is the largest it has ever been. In a world of growing buy-side assets but lower street liquidity, sharp corrections are more common. Dealer inventories of corporate bonds are clearly way down on where they were in ’07, but banks also appear more nimble in managing their mark-to-market risks and overall exposures on their securities portfolios.
“Liquidity” is of course an inherently nebulous concept and its amorphous character adds a layer of ambiguity to discussions of market conditions. This is a long-running issue and analysts of all stripes (i.e., across assets) have attempted to chase down the elusive concept using various indicators that they (analysts) believe are most appropriate for a given market. Obviously there’s some overlap when it comes what these indicators measure and for a discussion of the equities side of the equation, you might check out “‘Liquidity’s Heisenberg Uncertainty Principle’: Goldman Goes Looking For Market Liquidity, Doesn’t Find Much”.
In European credit, BofAML looks at number of trades and turnover for IG and HY. “Chart 15 shows that fewer bonds tend to trade on a daily basis [as] the number of trades in the corporate bond market has remained relatively stable in the past five years, despite a steadily increasing universe of available bonds to trade”, the bank writes, adding that they also observe a deterioration in liquidity “during the course of the year (chart 16) that’s been consistent since 2014.”
Unsurprisingly, respondents to BofAML’s survey (both in IG and HY) expressed more concern about liquidity for large trades. Here’s the breakdown on that:
For IG (left pane below) the bank finds that “the number of bonds that trade on a daily basis has declined from as high as 60% to ~35% of the sample.” The picture looks better for HY (right pane), although this year has seen a deterioration:
Notably, BofAML finds that in terms of bid/offer metrics, HY appears to be succumbing to worries about idiosyncratic blowups and jitters around rising dispersion in an environment where the CSPP bit is fading with the possible consequence of investors moving back up the quality ladder, allowing company- and sector-specific risk to manifest itself.
“We find that over the past 18 months b/o metrics have broadly deteriorated both in absolute (more notably) and per unit of spread (to a lesser extend)”, the bank explains, adding that “this deteriorating trend for b/o liquidity metrics has been consistent over the past five years and clearly reflects the lower appetite for sell-side firms to own idiosyncratic stories for risk management purposes.”
So where can investors turn to mitigate this? Well, CDS, naturally. Although the following is intuitive given that investors will go where the liquidity is when the waters get choppy, it’s worth noting:
We could say that CDS indices nicely complement the cash bond market, as CDS indices liquidity is actually countercyclical. We find that liquidity in CDS indices is actually positively correlated to market volatility. When the market becomes more volatile, credit accounts resort to trading CDS indices to manage risk and betas, increasing volumes traded via the product. In chart 58 we present the countercyclical relationship between CDS index trading volumes vs. market volatility.
The upshot to all of this is relatively straightforward. European credit investors are concerned about liquidity in the cash market as the ECB rolls back accommodation, as inflows dissipate and as the policy divergence between the U.S. and Europe makes the case for the former ever more attractive. The “sellside/buyside” disparity highlighted in Chart 2 only serves to heighten concerns.
Fortunately, there’s CDS and hell, if that’s not comforting enough for the buyside when it comes to managing the risks, I guess they could always short that new ETF that buys protection on € credit on behalf of clueless retail investors.