Bond Liquidity Falls 70% in Europe as Sales Soar: Credit Markets

Bond dealers made money manager Gary Kirk’s job much more difficult when he tried to sell debt securities at the end of the first half. After they gave him “excuse after excuse” he gave up.

“It was way more difficult than it should have been,” according to TwentyFour Asset Management LLP’s Kirk, who said banks offered prices well below what he expected or said they no longer did business in the notes. “Extracting a bid out of anyone was very, very difficult.”

Credit market liquidity has dropped by about 70 percent since the 2008 crisis and continues to decline even as soaring issuance boosts the total size of the market, according to Royal Bank of Scotland Group Plc. A European corporate bond issue now trades once a day on average, compared with almost five times a day a decade ago, according to RBS.

It’s tougher to trade even though sales of corporate bonds have surged more than 25 percent to about 565 billion euros ($758 billion) this year from 447 billion euros in the same period of 2013, according to data compiled by Bloomberg. Historically low yields fueled by unprecedented central-bank stimulus are prompting concern that a bubble is being created in the bond market, drawing warnings from regulators and analysts of future instability.

Illiquid Positions

The European Central Bank and the Bank of England both cited lack of liquidity in bond markets as cause for concern in their latest financial stability reports this year. The risk is that when sentiment changes and bondholders want to sell, they’ll all try to do it at the same time.

Managers should be hedging to offset the risk of taking losses on illiquid positions, said Kirk at Twentyfour Asset Management. “It’s going to be a challenge to exit, that’s the worry of every portfolio manager, and if it’s not, it should be,” he said.

The ratio between issuance and daily trading turnover is a “worrying sign,” according to strategists Stephane Deo and Ramin Nakisa at UBS AG in London. The lack of liquidity is a key issue and could prompt a sharp market over-adjustment, they wrote in a July 24 report.

“We have severe doubts about the ability of market makers to provide liquidity in a volatile scenario,” they wrote.

Low Volatility

Dealers are less willing to hold bonds while seeking a buyer than before the global financial crisis because of rules requiring banks hold more capital against their trading.

“There is a structural decline in dealers’ ability to warehouse risk,” said Alberto Gallo, head of macro credit research at RBS in London. “That’s an unintended consequence of regulatory demands and it’s the result of higher capital requirements and tighter risk limits.”

Higher trading costs increase the incentives for banks to either withdraw or focus on limited sections of the market.

Barclays cut about 5,000 jobs this year, with half of them at the investment bank, pushing the headcount to the lowest since 2007. The bank cut operating expenses by almost 1 billion pounds in the first half, it said on July 30. UBS is cutting 10,000 jobs and exiting most of its debt-trading business.

Banco Bilbao Vizcaya Argentaria SA, Spain’s second-largest lender, is focusing on some Latin American countries, southern U.S. states and southern Europe, Oscar Alvarez, London-based head of global credit, said in an interview on July 24. “Banks aren’t going to provide liquidity anymore so investors are going to have to step in,” he said.

‘Everyone’s Gone’

The banks’ pull back from market making has exposed an “underlying fragility,” according to the Bank of England’s half-yearly Financial Stability Report.

Like Kirk, Tatjana Greil Castro, a London-based money manager at Muzinich & Co., which manages about $27 billion in credit, noted the lack of trading as the first half ended. Yields on European junk bonds rose 23 basis points, or 0.23 percentage point, to 3.42 percent at the end of June from 3.19 percent on June 20, according to the Bloomberg High Yield Corporate index.

“It was such a small move, really not noticeable to anyone who doesn’t do this for a living, and everyone stepped away,” she said in a telephone interview. “In the past it would have taken much more. These days, when there’s the slightest change in mood everyone’s gone.”

(An earlier version corrected the currency in the fourth paragraph.)

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