As liquidity shrinks, bond trading becomes a grind

LONDON — Before the crisis, Olivier de Larouziere of Parisbased Natixis Asset Management (NAM) could sell €100 million worth of government bonds in a minute. Now it takes “minutes” and the extra time can cost him money.

For example, on Wednesday, when benchmark 10-year German Bund yields rose above 1% for the first time in nine months, they rose two basis points in less than five minutes in early trade. In price terms, that is a 0.1% loss.

This is the new reality for investors in markets where liquidity is shrinking, making it harder to find a counterparty willing to buy in the desired amount. When the market rallies — as it did for most of the past three years — not being able to sell bonds is not a big problem.

But many in the six trillion euro zone government bond market have been nickel- anddimed into heavy losses by this “liquidity premium” in the past two months, during which yields on benchmark German Bunds soared from record lows of close to zero and the top- rated asset lost 10% in value.

One of the sharpest ever selloffs in Bunds has brought back into focus the problem of diminishing liquidity. It has exacerbat- ed the rise in German yields that set the standard for interest rates paid by euro zone states, firms and consumers.

It has also changed the way many assets are traded. Investors say trades are smaller than they were, portfolios are more diverse to spread risk and the ability to get out of a position is a key factor in any decision to buy.

“There is a growing concern about liquidity in the bond market and we’re spending more time looking at the issues this presents, as is the industry as a whole,” said Bill Street, head of investments for Europe, Middle East and Africa at State Street.

Central banks buying bonds to conduct unprecedented stimulus programs have brought bond investors stellar returns for the past three years, but have sucked volume out of the market, making it less liquid.

Tougher bank regulations also reduce liquidity. Banks acting as market makers are less willing to build bond inventories until they find a buyer, as regulators require them to set cash aside to mitigate the risk of holding an asset.

Fund managers say the sharply reduced inventories that banks in Europe still hold are aimed mainly at satisfying demand from the European Central Bank for its trillion-euro quantitative easing program.

ADAPTATION

Reduced liquidity in bonds can spread to other markets. Often banks and other financial institutions use bonds as collateral to borrow cash. The harder it is to buy and sell bonds, the less willing investors are to pledge them.

It can also have distort sovereign borrowing costs.

Mr. de Larouziere, head of interest rates at NAM, says that although he rates Spain’s economic prospects higher than Italy’s, he prefers Italian long-term bonds as Italy’s debt market is twice the size of Spain’s, making it more liquid.

He holds less risky short-term bonds in Spain.

“Liquidity is probably the number one criterion when we take these views,” said Mr. de Larouziere, who has set up a special team of analysts looking specifically at liquidity.

Bill Street at State Street recommends setting up volatility limits to mitigate the impact of lower liquidity.

"As you see that trigger coming in you can de- risk... from high- risk stocks to low- risk stocks or from stocks into bonds