By Ian Fraser
Published: Financial Times
Date: 3 July 2011
There were raised eyebrows in the City when fixed-income manager Rod Davidson declared recently that lack of liquidity in the market was making it impossible for the managers of large bond funds to actively manage their portfolios – and by extension to justify the fees they charge.
Mr Davidson, head of fixed income at Edinburgh-based Alliance Trust Asset Management, claimed in an interview with The Herald newspaper that a halving of liquidity in fixed-income markets since 2007 had caused a form of sclerosis and was “the elephant in the room in bond investing [and] affects every large fund management group”.
A former global head of fixed income at Scottish Widows Investment Partnership, Mr Davidson tells FTfm the liquidity squeeze has become a semi-permanent feature of the market, making trading punitively expensive for the behemoths of the sector. “The banks continue to want to derisk as much as possible and don’t have the capital to chuck at their trading books – we don’t see that situation changing in the next couple of years.”
In 2007 bond fund managers were able to trade bonds at bid/offer spreads of 0.25 per cent. That widened to 2-3 per cent at the height of the crisis from September 2008 to March 2009. Trading spreads subsequently fell back to 0.4-0.5 per cent but have since crept up again to about 1 per cent on fears of the European sovereign debt crisis. Mr Davidson says: “It’s clear the banks don’t want any credit instruments on their books, especially given everything that’s going on in peripheral Europe.”
As a result, he adds, anyone managing a bond fund with assets of £1bn ($1.6bn) or more – with individual holdings of £10m plus – has their hands pretty much tied, “unless they resort to the euro market for greater cash liquidity or the CDS [credit default swap] market for greater active liquidity – but they’d be giving away yield in both cases. It is taking people a long time to trade out of an accumulated position of over £100m in a single, not very liquid bond.”
John Hastings, partner with consultants Hymans Robertson, agrees the tightening of liquidity is making trading tougher for fund managers, but says it is not a particular problem for end investors. “It is making the managers’ jobs more difficult – but that is why they are paid their money. I don’t think it’s alarming from the investor’s perspective unless it changes the fund manager’s method of managing the portfolio in a way that’s adverse to the investor return.”
He adds that the increase in spreads since the crisis “doesn’t stop fund managers from dealing but it makes them disinclined to deal unless they’re really sure of what they are doing, because every trade costs you money”. He suggests the development may even have a silver lining since it discourages churning. “There are an awful lot of investors out there who will comfortably hold a bond from when the company issues it right through to maturity.”
Ralph Frank head of solutions at consultants Cardano says: “There has certainly been a reduction in bond market liquidity as dealers have reduced the amount of capital they have made available to ‘warehouse’ bonds. However, back-to-back trade – where warehousing is not needed – has been largely unaffected. Bond markets are still relatively liquid, albeit not to the same extent as 2007.”
Mr Davidson says Alliance Trust’s £215m Monthly Income Bond fund, launched in June 2010, is suitable for the new environment as it is much nimbler than the unwieldy behemoths of the industry, and is not plagued by hard-to-shift legacy holdings. He says the fund has been capped at £1bn and has a self-imposed limit of 100 holdings.
Another recent trend in the global bond markets have been large outflows from high yield funds. Mr Hastings says the exodus may simply be profit-taking. “People think that period of strong performance has run its course, and are worried about Greece – how that’s affecting the euro and worried whether we’ve entered a less safe environment. “It’s possible to argue that, at the top, the yields had compressed too far and all you’re getting is normalisation. The problem with all trends is they tend to go a little too far in both directions.”
Cardano’s Mr Frank adds: “The current outflows from high yield funds are consistent with the risk aversion prevailing across many investment markets. There may also be an element of profit-taking, given the strong performance of high yield over the past two years.”
On the overall problem and whether big bond funds are becoming unmanageable, Mr Frank says: “There are a range of other funds (such as unit trusts, mutual funds and institutional funds) that manage to provide daily liquidity off sizeable asset bases, such as the $200bn plus Pimco Total Return Fund [run by Bill Gross].
“I accept there comes a point where a fund’s returns are adversely impacted by asset growth. However, this differs according to the area in which the fund invests as well as the manager’s approach. Rod Davidson and Bill Gross clearly have different points.”
This article was published in the Financial Times’ FTfm section on July 3rd, 2011.