Corporate credit has been among the best performing asset classes of 2012. Although the sector has returned 6% so far this year, as banks exit their traditional broker dealer roles, liquidity risk is rising alarmingly.
The rapid decline in market making by the biggest financial institutions has caused unease among sector managers, who warn the current level of credit yield has a huge amount of embedded risk.
The iBoxx corporate non-financial index currently yields 2.98%, the lowest ever recorded. But with the number of counterparties falling rapidly and bid/offer spreads actually expanding through the last five months of yield compression, many question how sustainable that pricing is.
‘It is already making it hard to find pricing,’ said Marco Pabst, chief investment officer at boutique ACPI. ‘This will eventually show up violently in prices. The spreads are hiding quite a bit of credit risk, especially in non-tier one, which could quite easily lose a lot of value [if risk appetite retreats].’
A recent report from the US Treasury’s Office of Debt Management reported that global broker-dealer bond inventories have fallen more than 70% since the peak of more than $250 billion in 2007.
Anecdotal evidence from one major UK bond manager’s conversation with a big four British bank suggests that domestic institutions have cut their commercial paper holdings to 10% of the equivalent figure in 2007 – and that residual holding now includes much larger amounts of CDS.
‘A reduction in liquidity/wider bid-offer spreads has both an upfront cost to existing investors, who have to mark their existing holdings at wider levels, as well as an ongoing cost for issuers and investors,’ noted the Treasury report. At the same time, the collapse in lending following the credit crunch and associated increase in bond issuance has caused the overall stock of outstanding corporate paper to more than double to above $5 trillion.
Typical bid offer spreads on investment grade credit – which exploded from below five basis points (bps) to almost 35bps in 2008, falling to 7bps since – have begun to rise sharply again, approaching 15bps.
Rise in issuance
With the massive rise in issuance, turnover in debt issued in the previous 12 months is 10% higher than in 2006. For older maturities the decline in brokerage has fallen sharply however, with 29% lower turnover for paper between four and five years after issuance and 25% less for older paper.
‘While we used to be able to get pricing from a single bank, now we find that we have to approach six or more counterparties.’
The continuing need for bank recapitalisation, and new requirements for capital ratios associated with Basel III and other recent regulations, means the issue is likely to continue to worsen for some time, he added.
Last week, Moody’s threatened 17 global banks with downgrades due to their continued reluctance or inability to increase their capital ratios.
‘The consequence will inevitably be reduced [market] efficiency,’ said Sheard. ‘In terms of liquidity, fixed income markets are going to become more volatile.’
While saying that liquidity was a growing challenge for sector managers, Stephen Snowden, manager of the Kames Investment Grade Bond fund, emphasised that market inefficiency was as much an opportunity for an active manager as it was a challenge.
He added that credit spreads were relative. ‘Spreads may appear low in absolute terms, but in relative terms the [iBoxx] credit spread over the base rate of interest is wider than it has ever been before,’ said Snowden.
He added that while the biggest counterparties had retreated, a broader range of brokers had replaced them. ‘We have gone from a diving pool to a toddler’s splash pool: liquidity is less deep but much more broad.’
Of greater concern, he added, was the substitution of CDS for cash bonds where it was hard to find liquidity in the market. Managers such as John Pattullo of Henderson and Richard Woolnough's M&G Optimal Income have recently run a high exposure to CDS.
Where short positions had been taken synthetically, sudden rallies in risk appetite combined with low trading volumes made it very hard to gain access to market upside while the short end was squeezed, Snowden explained.
The potential challenges inherent in trading CDSs were illustrated by a $2 billion loss on a JP Morgan hedge where precisely this sort of basis trade took place.