Recently there are more and more reports about a perceived lack of liquidity in secondary bond markets.
For example Fund Traders dig deep for bonds (WSJ, Paywall)
Most Commentators blame the tide of regulation that has forced market makers to drastically reduce their bond inventories.
This may be a valid point but one should not forget that some other aspects could be more relevant.
The bond trading business has expanded enormously during the past 20-25 years. Until 2007/08 volumes and staff levels increased to what in retrospect can only be described as unsustainable levels. Some retrenchment was inevitable, with or without added regulation. This naturally has an effect on the volumes that the dealer community can handle.
Technology may play an incremental role but many more complicated transactions still have to be done over the telephone, albeit with the aid of messaging or email services. Full automation is still a distant prospect, especially when there are tens of thousands of different bond issues outstanding. 'Do you want to kill the goose that lays the golden eggs?' asked the head trader of the erstwhile Credit Suisse White Weld in the late 1970s in a note to a colleague who wanted to introduce technology into the bond trading business. In my opinion he still would not need to worry too much.
The level of interest rates has - and will - have to play an important part in the lack of liquidity. The big bull market in bonds has played itself out, rising markets create turnover. At best markets from now will move sideways - creating less and less profitable trading opportunities. At worst they will enter bear territory and declining bond prices traditionally mean lower profits and lower volumes. Only the best traders will be able to prosper in a climate of fear and pessimism.
The explosion in the amount of outstanding bond values and the corresponding expansion of the buy-side (who would ever have thought that a fund manager less than 30 years old would control billions in assets?) make it virtually certain that there will not be enough liquidity to allow a smooth exit through a (very) narrow door when markets turn. Is any trading venue going to be able to take the other side when the likes of Pimco or BlackRock want to implement a drastic shift in their investment strategy?
So the old saying holds: Markets will fluctuate, this will create opportunities for those who are a step ahead of the crowd. Expect sharp moves and review your risk management process to be able to cope with extreme volatility if and when it arrives - as surely it will one day.
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