In the UK, during dry conditions, the government bans the public from using hosepipes in order to conserve water. In 2022, the sell side has imposed its own version of this across many bond markets, stepping further back from market making than ever before and thus reducing available liquidity. This is creating problems for asset managers as they try to trade in and out of positions.
Banks are not losing money due to their strategy. Multiple reports have found bank’s trading revenues are allowing them to generate positive returns in the fixed income, currency and commodities (FICC) space. At a time when bond issuance and M&A activity is in decline, this is great news for the sell side.
It is becoming far more expensive for issuers to raise debt. Analysis by Overbond, which provides a Corporate and Government Bond Intelligence (COBI) price tool, has found that spreads on bonds issued by real estate companies widened across all tenors over the first half of the year for both EUR and USD-denominated bonds.
“The spreads of these bonds widened by 133% for EUR-denominated bonds and 65% for USD-denominated bonds,” Overbond wrote in a recent note. “In the 10-year bucket, spreads of EUR-denominated bonds in the real estate sector widened the most (121%) followed by materials (115%) and consumer discretionary (100%). In this tenor bucket, spreads of USD-denominated bonds in the information technology sector widened the most (85%) followed by real estate (65%) and healthcare (59%) [while] bonds in the consumer discretionary sector saw the second highest percentage widening of spreads (115%) of EUR-denominated bonds averaged across all tenors, followed by utilities spreads (103%).”
This has reduced issuer activity and deals in the fixed income primary market, which has been propping up investment banks during the prolonged low-rate period. As volatility increases, secondary markets become more profitable again, and rapid rate moves are a direct cause of volatility.
The problem created by banks’ more profitable but cautious approach to liquidity provision is being felt keenly by investors. Bid-ask (BA) spreads are widening; mean US investment grade BA spreads have moved from 2.97 basis points in early January to break the 5.5bps mark in both June and July according to MarketAxess data. While that is delivering good returns for sell-side firms, it is increasing trading costs for the buy side.
A bigger problem are bid-less markets. Banks cannot be forced to make markets, and face real barriers to doing so thanks to the cost of carrying risk on their books. Buy-side traders note that there had historically been a point of honour – rather than an obligation – on markets makers to provide a price.
A serious issue for some buy-side firms is that they are also too big to be supported by the sell-side. If these buy-side firms hold the inventory and banks are unwilling to be conduits for risk transfer, the traditional model for bond trading is bordering on broken in some markets.
Every year The DESK asks buy-side traders in the Trading Intentions Survey, who can best contribute to liquidity; the number one answer is always the buy side. If liquidity is either too expensive or non-existent, asset managers will need to reconsider how they engage in the market.
Firstly, they may need to use their inventory to support liquidity, through all-to-all trading. In doing that, buy side firms may want to consider if this support can also be used as a positive leverage to boost dealer engagement.
Secondly, portfolio managers may need to rethink what they are prepared to accept when trading, with some orders being filled in a less than optimal way so that they can be filled at all.
Finally, the market should not be constrained from developing its own solutions. If capital adequacy rules are to be maintained – thereby restricting bank risk taking – then other rules which limit market efficiency must be considered by regulators through the prism of liquidity.
Across the world farmers are explaining the serious economic effects of the droughts they are facing in 2022. It will be important for asset managers to speak up, and collectively find solutions, to the liquidity drought they are facing before a systemic problem occurs.
©Markets Media Europe 2022
