Global fixed income – the changing face of global liquidity
Global fixed income – the changing face of global liquidity
More regulation means less secondary market liquidity
There has been increased bank regulation around the world since the Global Financial Crisis (GFC). The purpose of this has been to improve the stability of banks so they can continue to provide core services during periods of economic stress. In addition, if a bank were to collapse, as happened during the GFC, the regulations aim to shift the burden of default from the tax-payer to the bondholder.
As a consequence of this regulation, banks have been required to improve their capital adequacy ratios (capital ratios are a measure of a bank’s financial strength, and its ability to absorb unanticipated losses). In doing this, the banking sector has reduced capital allocated to fixed income, currencies and commodities as these areas of the market are facing increasing costs of doing business coupled with a weak revenue outlook and becoming more capital intensive.
All of this has led to a fall in trading activity within bond markets which can create challenges for managing credit risk within bond portfolios.
Revenue pool for global core fixed income, currencies and commodity markets
Source: Citi Research Estimates
The challenges of managing liquidity in credit portfolios
In this environment, investment managers are having to draw on a greater breadth of liquidity indicators to navigate through the market cycle and a more focussed approach on underlying fundamental analysis (i.e. one that adapts to ultimately higher transaction costs, less liquidity and critical need for accuracy in forecasting, regime shifts and robust stress testing).
At AMP Capital, we believe the ability to measure liquidity risk starts with a clear understanding of the structural components of your core portfolio – i.e. what are your investors’ objectives going forward, and what are their liquidity needs likely to be?
Throughout 2015 there have been many approaches trialled by investment managers around the globe, designed to manage liquidity risk in credit portfolios.
Some of these have been traditional approaches such as simply adjusting to holding higher cash levels or applying sell spreads or gates, while others have been less conventional in their application. At AMP Capital we have tested the risk and return of a variety of ‘concept’ portfolios. These portfolios combine varying degrees of derivative overlays, designed to increase liquidity within portfolios. The results of this analysis indicate that this approach may enhance the potential to actively manage return outcomes – and have relatively small impacts on total volatility for credit portfolios. We believe that approaches such as these are a good alternative that investors may wish to think about when managing liquidity risk in corporate bond portfolios.
Article by David Carruthers, Head of Credit and Core and Linden Smith, Credit Analyst