Markets & Economy

Recent headlines suggest that bond investors are bracing for heightened volatility in fixed income markets, with pundits citing an eventual Fed rate hike as the catalyst that could give rise to further market gyrations. As the Fed moves toward policy normalization, investors are concerned that there could be a supply/demand imbalance. The fear is that once the Fed decides to raise interest rates, losses could incite a massive unwinding of positions that investors have crowded into and/or a spike in redemptions. This could prompt forced selling by fund managers of their portfolio’s most attractive, liquid assets if cash levels are insufficient to meet redemption needs. Should such an event materialize, there would be downward pricing pressure across the fixed income space and potentially an inability to offload assets. What chain of events has led investors to be concerned about such a possibility?

In the wake of the financial crisis, bond market liquidity and market-making activities have become more concentrated, largely in the most liquid bonds. Dodd-Frank’s Volcker rule banned proprietary trading by banks, and the regulation along with higher capital requirements precipitated a reduction in dealer inventory. Primary dealers in the U.S. have notably decreased their corporate bond holdings while increasing their U.S. Treasury positions (Chart 1). Simultaneously, the average size of relatively large trades of U.S. investment grade corporate bonds has been cut by these market makers (Chart 2).

Source of charts: Bank for International Settlements, 85th Annual Report. Analysis: Manning & Napier.

Meanwhile, the Fed loaded up its balance sheet with fixed income securities through three iterations of quantitative easing, increasing total assets held from under $900 billion in 2007 just prior to the recession, to approximately $4.5 trillion today. This unprecedented stimulus resulted in reduced levels of private sector-held government bond supply, in turn shifting demand to the corporate and municipal bond markets.

Concurrently—owing to the Fed’s zero interest rate policy—corporate bond issuance as well as outstanding U.S. investment-grade debt has roughly doubled, and there are significantly more debt issues being traded across sectors as a result. Add in the proliferation of automated trading and the result is a volatile fixed income landscape (Chart 3) that has investors crowding into the same trades, namely long positions in U.S. high yield debt and bank loans. The changed environment has also led to lower turnover and sharper price movements.

Source: FactSet. Analysis: Manning & Napier.

We believe illiquidity concerns are valid, and investors should certainly address the topic of liquidity management with their investment manager in an effort to understand how potential bouts of market illiquidity may impact their portfolio. Indeed, many investment managers have ramped up efforts to manage liquidity risk. Some measures taken include increasing cash allocations in portfolios, increasing use of exchange-traded funds (ETFs) and/or derivatives, and taking on lines of credit. Nevertheless, our view is that these approaches are value destructive when used as a tool of last resort, as they can weigh on portfolio performance via increased trading costs or other added operational expenses.

We view larger bond funds as the most susceptible to liquidity issues due to the size of their trades and the extent of their trading activities. These larger funds are characteristically forced to invest in more liquid issues to manage liquidity risk, and this can lead to missed opportunities.

At Manning & Napier, we don’t view illiquidity as a problem for our fixed income portfolios, given our size and investment style. Our size allows for a more nimble fixed income investment approach, one in which we can derive significant value through the purchase of smaller, less liquid securities that we believe can offer a much more attractive valuation of underlying fundamentals. In fact, we’re typically a provider of liquidity due to our strategy of buying into weakness and selling into strength. We would likely look to take advantage of a selloff, should one unfold, by being net buyers, in turn providing liquidity at a time when its cost is at a premium. Investors should keep in mind that though volatility may arise, it is important to remain focused on long-term investment objectives, and not overreact to short-term periods of market dislocation.