While the prospect of an increase in US interest rates is good news from a fundamental point of view the rate rise, when it happens, could prove to be a challenging experience for many investors, global asset manager AllianceBernstein (AB) said today.
“The rate rise will be evidence that the US recovery is becoming established,” said Doug Peebles, AB’s Head—Fixed Income.
“Normally bond markets would take such a development—particularly one so well flagged beforehand—in their stride, but these are not normal times.”
Peebles—co-author of a new AB research paper (attached), Playing With Fire: The Bond Liquidity Crunch and What to Do About It—said that the expected rate rise is unusually fraught with risk for fixed-income investors because of the historically low levels of liquidity in bond markets, created as a result of regulatory, monetary and financial industry actions in the aftermath of the 2008 global financial crisis.
“This illiquidity potentially exposes bond holders to high levels of price volatility, mark-to-market losses and perhaps even the inability to buy or sell securities when the Federal Reserve raises rates.”
Liquidity in financial markets is the ability to buy or sell securities in a timely way at prices acceptable to both buyers and sellers. A rise in US interest rates could cause US bond yields to rise and the price of bonds to fall (bond prices and yields are inversely correlated), triggering a rush to sell. Low liquidity may mean that many investors who wish to sell will be unable to do so without incurring a loss.
“Tighter global bank regulation introduced since the financial crisis is a major cause of illiquidity,” said research paper co-author Ashish Shah, Head—Global Credit at AB. “Previously banks had been active market participants, carrying large amounts of inventory on their balance sheets. Since re-regulation, however, they are now less inclined to take such risks.”
Other causes include the quantitative easing, or bond-buying, programmes introduced by a number of central banks to maintain confidence in financial markets, and the proliferation of risk-aware strategies that often rely on similar signals to determine timing of de-risking.
“This has helped drive yields to historic lows, forcing yield-seeking small investors into riskier securities, such as low-rated corporate bonds or overvalued growth stocks,” said Shah. “Consequently, too many investors are chasing the same opportunities, resulting in crowded trades which are illiquid by nature.”
Illiquidity has been further compounded by large financial institutions which, seeing the deterioration in liquidity and the potential it’s creating for price volatility, are shying away from investing over the long term.
Typically they restrict themselves instead to short-term market positions or invest in products which are expected to de-risk when market uncertainty increases. The latter course of action has led to substantial inflows into hedge fund, risk parity, and volatility management strategies. In many cases, these strategies deploy significant leverage to achieve returns.
“More troublesome is the potential for such investors to attempt to de-risk when volatility increases from the currently depressed levels—a move that could result in illiquidity and draw-down risk, said Shah.
According to Peebles, however, it’s not all bad news.
“There are steps that investors can take to mitigate illiquidity risk, such as diversifying their fixed-income exposure with a broad multi-sector strategy, by being creatively long volatility, taking a contrarian approach to avoid crowded trades and considering multiple investment horizons.
“Essentially the key to mitigating liquidity risk lies in taking an active approach to investment based on sound research. In these uncertain times investors, in our view, should take the added precaution of ensuring that their investment managers fully understand liquidity risk and manage it appropriately.”
