People walk past an electronic board displaying market indices in Tokyo June 22.Thomas Peter/Reuters
There are three things that matter in the bond market these days: liquidity, liquidity and liquidity.
How -- or whether -- investors can trade without having prices move against them has become a major worry as bonds globally tanked in the past few months. As a result, liquidity, or the lack of it, is skewing markets in new and surprising ways.
Spain, for instance, must pay more to borrow money than Italy for 30 years, even though Spain is considered safer by credit raters. Why? The Italian bond market is twice as big as the Spanish one -- and, therefore, more liquid.
The same thing is happening around the world. Bonds in smaller, less-traded markets like Finland, Singapore and Canada are starting to fall out of favour. And with the Federal Reserve preparing to raise U.S. interest rates, investors want to know they can sell in a hurry if debt markets turn volatile.
"Liquidity is our number-one criteria in country selection," said Olivier de Larouziere, the head of European interest rates in Paris at Natixis Asset Management, which oversees about $367-billion.
Concern liquidity is drying up has intensified as the global bond rout that erupted in April erased more than a half a trillion dollars from sovereign debt and triggered swings some have likened to a once-in-a-generation event.
Liquidity Premium
Aberdeen Asset Management Plc has already said it arranged $500-million in credit lines to fund potential withdrawals. In the U.S., regulators will meet with Wall Street firms to discuss how they can prevent post-crisis regulations and central bank policies from sparking a meltdown when the next selloff occurs.
Some investors aren't waiting to find out. In Spain, where a slump in repurchase agreements and trading of bills sent government-debt turnover in April to lows not seen since at least 2012, they're starting to demand a bigger premium to own the securities, data compiled by Bloomberg show.
Yields on 10-year Spanish bonds reached 2.54 per cent on June 16, and rose to the highest versus Italian securities since the end of 2013. Spain's 30-year bonds are also yielding more than comparable Italian debt. For much of the past year, the relationship was reversed as investors preferred Spain.
Part of the shift has to do with the rising cost of trading as liquidity dries up. The difference in yields for buyers and sellers of Spain's 10-year notes -- known as the bid-ask spread -- is almost double that in Italy, the data show.
Extra Yield
That's made Natixis more confident in owning Italy's longer-maturity bonds versus those in Spain in its Souverains Euro fund, which beat 93 percent of like funds during the past year, de Larouziere said.
It's not just Spain that's getting hit. Since the bond selloff started in mid-April as signs of euro-area inflation emerged, the extra yield buyers require to invest in Finland instead of Germany -- where the bond market is 10 times larger - - has almost tripled.
"Highly rated, small bond markets can become relatively illiquid," said Chris Wightman, a London-based money manager at Wells Fargo Asset Management, which oversees about $493-billion. "Providing liquidity for our underlying clients is a paramount investment criteria for us."
On Monday, yields on Italy's benchmark debt dropped as much as 14 basis points, or 0.14 percentage point, below last week's close. Spain's also decreased 14 basis points to 2.14 per cent as of 9:55 a.m. in New York.
Unexpected Swings
In Asia, a divergence is also appearing between Singapore and Australia, the region's two highest rated borrowers. Singapore's benchmark 10-year securities have underperformed the larger and more liquid Australian market in the past month.
"Australia is still liquid," said Kei Katayama, who trades non-yen debt in Tokyo at Daiwa SB Investments, which oversees about $47-billion. "It's a very good reason to keep a focus on the Australian fixed-income market."
Australia's 10-year yield has risen about three basis points in the past month to 2.95 per cent, while Singapore's has jumped about 20 basis points.
Investors told the Bank of Japan this month that while bid- ask spreads are narrow for small orders, more sizable transactions can cause unexpectedly large price swings, according to minutes of meetings held on June 11-12.
Bond investors are fixated on liquidity after years of easy-money policies by the Fed and other central banks locked away trillions of dollars of supply and prompted everyone to crowd into the same trades.
Tiny Exit
Regulations designed to limit risk-taking have also caused big banks to back away from their traditional role as middlemen by reducing the number of willing buyers, exacerbating price swings and potential dislocations as the Fed moves to lift rates for the first time since 2006.
"When the unwind comes, like we've seen in the past few months, it comes abruptly and sharply as the exit door is tiny," said Ryan Myerberg, a London-based fund manager at Janus Capital Group Inc., which oversees about $190-billion.
This month, yields on Spanish 10-year notes have fluctuated in a range of about 0.7 percentage point. That's about 1.2 times as much as both Germany and Italy and almost double the magnitude of swings that have occurred in Treasuries.
Still, outright transactions of Spanish government debt are higher in 2015 that last year. An Economy Ministry official defended the appeal of Spanish debt markets, saying the drop in total trading owes mostly to repos and such declines have occurred across Europe.
No Alarm?
Despite all the hand-wringing over being able to sell at a moment's notice as markets get more volatile, JPMorgan Asset Management's Iain Stealey says that for long-term investors like himself, there's little reason for alarm.
"We're not putting on positions in the morning to unwind them in the afternoon," said Stealey, a fixed-income manager at JPMorgan, which oversees $1.7-trillion. "That allows us to take positions on."
That hasn't stopped some investors such as Canada's Mawer Investment Management from looking toward bigger, more-liquid bond markets as a way to diversify. The Calgary-based firm, which oversees $24-billion, started its first foreign bond fund last week and will invest in the U.S., the U.K. and Europe.
"We recognize that other larger markets are more liquid than the Canadian bond market, which does naturally make Canada more vulnerable," said James Redpath, a fund manager at Mawer.
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