The financial industry needs to collectively deal with lower liquidity in bond markets, says Robeco’s head of risk analysis.
Structural changes in the market are making it more difficult to quickly trade bonds, particularly under stressed conditions, Robbert Vonk warns. Robeco has taken internal measures to protect clients and is also working with regulators and other asset managers to discuss industry-wide solutions. In addition, clients are advised to have a long-term investment perspective and to act counter-cyclically.
Liquidity in the fixed income markets globally has been negatively affected since the financial crisis of 2008. Before the Lehman collapse, banks could hold substantial amounts of bonds purely for trading purposes, and their balance sheets functioned as a buffer. Following the crisis, regulation enshrined in Basel III forced banks to abandon this function in order to reduce risk. At the same time, mutual funds grew in size, following increased client interest for higher yielding assets. The lack of a buffer and more concentrated holdings in mutual funds created substantial volatility, leading to bigger shocks in markets potentially exacerbating client reactions (for instance selling in bear markets).
A second problem has been created by the introduction of quantitative easing in 2008, in which central banks created new money and purchased government bonds with it. Eight years later, some central banks own up to one-third of their domestic bond markets, taking these securities offline. The European Central Bank is now also buying non-bank corporate bonds, which may make the situation worse.
Meanwhile, after persistently falling interest rates, many investors think that bond yields cannot fall any further. If yields start to rise then prices will start to fall, potentially starting a stampede to sell them. And if everyone tries to sell at once, the market faces a massive problem, Vonk says. “It is in the industry’s and clients’ interest to come up with measures to avoid a disaster scenario like massive fund closures in certain asset classes”.
The problem is exacerbated because most asset managers allow clients the freedom to trade into funds on a daily basis. This gives investors the confidence that they can always get their money back – or quickly top up investments should they wish. But it leaves asset managers vulnerable to a sudden exodus if a market turns unexpectedly, as we have recently seen with the closure of several UK real estate funds following the Brexit vote.
“The client perception of liquidity can be even more misled by the wide offering of exchange traded funds, which can be traded on an intraday basis, investing in markets which are essentially illiquid,” says Vonk. “This can draw the wrong type of client to certain asset classes.”
Robeco has its own measures to ensure the stability of its extensive range of funds. “There are several safeguards: firstly, through proper risk measurement and secondly, through risk mitigation,” Vonk assures investors.
“Robeco has a comprehensive liquidity risk framework incorporating the dynamic that exists between liquidity risks related to assets on the one hand and funding on the other. Asset liquidity risk arises when transactions cannot be conducted at quoted market prices due to the size of the required trade, or, worse, when they cannot be conducted at all.”
“This type of risk tends to be compounded by other risks: when markets are falling or are very volatile, or when the creditworthiness of counterparties deteriorates; at these times, liquidity tends to dry up. Funding liquidity risk relates to the ability to redeem fund clients without significantly impacting the value of the portfolio. This kind of risk will only arise if there is limited asset liquidity, so the latter is dependent on the former.”
Robeco’s risk policy focusses on verifying whether the current portfolio is liquid enough to meet substantial future redemptions, Vonk adds. “If not, the portfolio will explicitly be discussed in the Risk Management Committee and measures will be taken.”
‘We have strict rules to make sure we have sufficient cash buffers’“Additionally, exposure to illiquid instruments is restricted at portfolio level. And Robeco maintains a detailed contingency plan which outlines the course of action in the event of severe liquidity crises, either as a consequence of severe cash outflows or unusual market distress.”
“We also have strict rules to make sure we have sufficient cash buffers. For instance, the Robeco High Yield Bonds fund holds a minimum of 5% of the fund in cash equivalents. In more stressed situations this can go up to 7-10% of the fund held in cash.” Robeco has also ensured that the funds have the ability to temporarily run a deficit.
Among the more technical measures, swing pricing is applied to all Luxembourg-domiciled funds to protect the interests of long-term shareholders from the impact of transaction costs resulting from subscription and redemption activities by other shareholders.
That said, the industry still needs more structural measures for some asset classes, says Vonk. “We strongly believe that the industry can benefit from a further harmonization over different jurisdictions with respect to the risk management tools available to fund managers,” he says.
“This includes tools such as notice periods, and the availability of anti-dilution practices, like swing pricing, which will ultimately benefit the fund’s investors. Moreover, in order to reduce the likelihood of material mismatches in offered versus available liquidity, authorities should have a clear stance on what trading frequencies are considered acceptable for certain asset classes.”
“This needs coordination though. Nobody is willing, for example, to unilaterally move away from daily liquidity to say, 10-day liquidity or monthly liquidity. If your neighbor isn’t doing it, and you start doing it, you can be sure that everyone will exit the fund.”
Robeco is actively collaborating with regulators and other interest groups to consider implementing a cross-industry response. The firm is also working closely with industry associations such as the International Capital Markets Association (ICMA), contributing to a paper entitled ‘Managing fund liquidity risk in Europe’ that was presented to the European Fund and Asset Management Association for discussion in April 2016.
‘Slowly we have been turning towards the same vision’
“We have frequent discussions on this with our fellow asset managers,” says Vonk. “Slowly we have been turning towards the same vision that something needs to be done. And we don’t want regulation to be counter-productive in that by mitigating a certain risk it creates a new one. So we need good interaction with the regulators so we can have a discussion on the proper way of dealing with it.”
He says a sign that the industry is moving in the right direction is the recent consultation paper by the Financial Stability Board (FSB) entitled ‘Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities’. “This paper outlines very sensible proposals to harmonize and make the industry and markets more resilient to this low liquidity environment,” says Vonk.
Investors can also help by adopting a long-term approach to investing and not panicking during market shocks such as the recent Brexit crisis, Vonk concludes. When the UK voted to leave the EU in a referendum on 23 June, corporate bond yields rose substantially. In this case, rather than everyone trying to sell at the same time, they all tried to buy at the same time. Bond yields later stabilized once the dust had settled.
“We advise clients to have a long-term perspective when investing in certain asset classes and, in line with Robeco’s own investment philosophy, we advise people to invest in a counter-cyclical manner, so to stay ahead of the curve.”
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