We have been reading a lot about the inherent dangers in the bond market given the low rates and the potential for interest rates to rise. While rates are low given historical spreads for most sectors, and the potential for higher rates both at the short and long end remains real, we will focus this brief piece on another risk that may be percolating.

Liquidity risk is the risk that the price of a security will not be able to be sold in the market due to a lack of interested buyers close to the current price. In a serious liquidity crisis, even high quality securities can lose value quickly before equilibrium is restored.

According to Simon Ejembi in a Punch article dated April 22nd 2014, The research department of the International Organisation of Securties Commissions said that, “Bond investors now face higher liquidity risk due to new regulation and interbank controls in the wake of the financial crisis.”

“Combined with the introduction of more transparency, this has made dealer banks to step back from their market-making role, causing a reduction in phantom liquidity. Bond investors now face higher liquidity risk as a result.”

The traditional inventory practice that is part of market making has been curtailed significantly by banks as regulations that curtail risk assets has dried up corporate bond market liquidity to a potentially dangerous level.

Nasdaq.com listed an article provided by Seeking Alpha that delves into a couple major issues with regard to the bond market. Namely, the major source of liquidity has been driven by retail investors who have piled into bond ETFs and funds. A significant portion of these funds has been poured into big name products such as AGG(I-Shares Barclays Aggregate Index) and LQD(I-Shares Investment Grade Corporate Index).

However; as the article points out very importantly, the market’s structural liquidity condition has gone in the opposite direction. Dealer inventories of corporate bonds have plummeted by nearly 75% from pre-crash levels, meaning that the ratio of dealer inventories to bond fund assets has virtually been vaporized. In 2008 that ratio stood at 15%, but presently it is only 1.5%. Likewise, daily trading volumes have been cut in half since the crisis.

The abundant liquidity that the Fed provided caused a major mispricing of liquidity so that the liquidity premium generally ascribed to debt assets has been absent.

Basically this means that when the conditions change, the price for these bonds may be well below current levels. Considering many firms use these ETFs for their core strategic holdings, it is a very good time to examine them and to also talk to your mutual fund manager to discuss this issue.

We recommend choosing a manager who is able to price liquidity appropriately and to be able to build and manage a portfolio that holds proper nimbleness and liquidity.

Sincerely,

Tom Koehler-CIO

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