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Market volatility drives fresh liquidity concerns

By Jason Conway, BNY Mellon

Volatile markets and rising unpredictability are driving renewed concerns about liquidity risks in global bond markets and placing a heightened focus on risk management, says Insight Investment product specialist Andy Burgess.

As markets enter 2017, many investors are maintaining a more cautious outlook, following a turbulent 2016. Rising market volatility was a key theme last year, as investors navigated sharp troughs and spikes fuelled partly by growing global political uncertainty.

Capricious redemptions have raised concern about the ability of funds to sell underlying holdings in time to meet any sale requests. In October 2016 rating agency Fitch said this risk had reached an all-time high, expressing doubts about European bond fund managers’ ability to fully meet redemption requests in times of market stress.

In the fixed income sector, the US high yield bond market has faced significant challenges. In December 2015 US investment house Third Avenue was forced to shut a US$800m high yield bond fund following a wave of redemption requests. This prompted fresh scrutiny from US regulator the Securities and Exchange Commission, which asked a raft of high yield bond funds to provide greater details of their holdings and investor redemptions last year.

Commenting, Andy Burgess, product specialist at Insight Investment says: “We are not alone in noting deteriorating market liquidity, especially within lower quality credit markets. More generally, banks are clearly stepping back from being providers of liquidity given the increasingly higher capital requirements and tougher regulatory environment they now operate in.”

Fund managers can take several steps to guard against the potential risks of illiquidity in order to protect their clients. Tightening liquidity has prompted a number of portfolio managers to increase the size of their bond trading teams, encourage their traders to overhaul their technologies and increase the level of communication between managers and those executing bond deals in order to minimise liquidity risk.

According to Burgess, declining liquidity also encourages managers to reassess their overall approach to both wider trading strategies and portfolio risk management.

“Managing bond portfolios in a lower liquidity world has several impacts. Firstly, there is greater focus on the downside and both the length of investment horizons and what happens if something goes wrong and a manager is forced to hold specific stocks to maturity,” he says.

“Building that into risk premium, the liquidity of a bond is an important part of the decision to invest. Thin markets can also lead to more pronounced market movements for given risk events. This is true for a wide range of sectors including equity, fixed income and even occasionally in foreign exchange.”

Tightening of market liquidity means managers will have to be ever more watchful they match the liquidity of underlying assets to that within their funds. However, Burgess adds that illiquidity in itself is not always a major problem, with much depending on the individual composition of a portfolio.

Either way, adapting trading strategies and effective risk management look set to remain key themes in a 2017 market where liquidity may not always be guaranteed and which could face a range of new political and economic bumps on the road ahead.