Liquidity: has the tide now turned?

The recent shift in a number of structural factors is now contributing to a decline in liquidity, or the ability to sell a bond at a reasonable price in a reasonable amount of time, for fixed income investors.

Interest rates are rising, inflation is up, volatility is on the increase and geopolitical risk continues to weigh on markets. However, the interplay of these macro developments is only part of the challenge facing fixed income investors at the moment.

The changing emphasis of global central banks means that while quantitative easing was used to stimulate economic conditions after the financial crisis and the pandemic, in today’s more inflationary environment, central banks are now reining back, or ‘tapering’, their asset purchases.

Quantitative easing has been an important prop to both bond and equity markets in recent years. The combination of abnormally low interest rates and abnormally large quantitative easing programmes has benefited almost every asset class.

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However, central bankers have been keen to see interest rates return to levels closer to historical norms for some time. This would give them greater ammunition to tackle inflation within the economy in the event of a new financial crisis or recession.

So as markets begin to adjust to a period of ‘normalisation’, the impact is being watched closely as it ushers in the next phase of the credit cycle. It is useful to think about these macro developments in terms of three Ds: dislocation, devaluation and demanding conditions.

Fixed-income investors have not needed to worry about liquidity for the past decade when the rising tide lifted all boats, but in today’s more volatile and dislocated market, investors need to be more discerning.

As markets adapt to the changing macro environment and become less dependent on liquidity, this will lead to further dislocation in some segments of the credit market. In other words, there is likely to be a clearer demarcation between higher and lower quality companies. Given the removal of liquidity, we also expect to see a degree of yield curve and credit issuer dislocation which we anticipate will generate further alpha opportunities.

Amid heightened volatility and dislocation, the underlying risk-return dynamics of active bond portfolios are more likely to be exposed. Making calls on the direction of bond markets in an attempt to generate returns (also known as ‘levered beta’) – which can at times pay off in risk-on scenarios – can fall down in more volatile environments. Relying solely on top-down decision making and macroeconomic indicators can expose portfolios to more binary and volatile outcomes.

In contrast, the alpha that investors can derive from a bottom-up approach involving fundamental credit research and technical analysis is amplified, adding even more opportunities and value than it would in less dislocated markets, providing fixed income investors stay focused and patient.

Bond valuations were stretched at the end of last year and while they are more attractive now, they remain relatively high even post the recent market sell-off. Although valuations have reduced there is still room for them to fall further. We are very close to the turning point, especially for investment grade credit. Other risk assets, such as high yield and equities, have not fully priced in the macroeconomic risks.

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Given today’s more demanding market conditions we expect to see more labour-intensive research and more in-depth fundamental analysis which will place further demands on fund managers. We also anticipate a greater demand for high quality bonds which will only increase as recession risks rise.

We should not wait for a recession to prepare for one and bottom-up security selection is more important than ever to generate alpha from such market dislocation.

Kunal Mehta is head of the fixed income specialist team at Vanguard