LONDON: Emerging market bonds, in high demand after this summer’s rush back to developing world assets, nowadays barely change hands after their initial sale, forcing specialist funds to seek alternative routes to buy and sell scarce debt.
High-risk debt categories have became casualties of tighter regulation since the 2008 crisis, as the higher cost of holding such securities on balance sheets and a ban on proprietary trading desks has seen fewer banks making markets by holding large inventories of bonds for trading purposes.
All evidence points to steadily declining trading frequency, with BNP Paribas estimating last year the average stock of an emerging dollar bond traded less than twice a year, down from 4-5 times in 2007.
Fewer than a fifth of emerging companies’ bonds trade every day, according to a study by ratings agency Fitch.
To mitigate this squeeze in daily trading volumes, investors are employing strategies like using electronic trading to maximise their access to potential counterparties, or holding extra cash and short-dated assets. Some are even taking market-making roles themselves to keep markets moving.
Trading frequency — or liquidity — may have dropped 65-70 per cent in the past two to three years, estimates Sergey Dergachev, senior portfolio manager at Union Investments.
Up to 90 per cent of his bond buying is now done on new issue markets — picking up debt either direct from sellers or from other funds which resell allocations soon after launch.
“The trend with new issues is that in two weeks the liquidity is gone,” Dergachev said.
The fear is also of being unable to sell bonds in a falling market where banks are not around to act as shock absorbers.
“Liquidity has become paramount for us,” Dergachev said. “If for tactical reasons we have any illiquid bonds in the portfolio and they have performed well, we try to get rid of them.”
Cash and yield premiums
The liquidity issue is not just a headache, it can seriously impact returns. A fund that urgently needs to sell a large volume of securities, for example, may have to accept lower prices if its clients are demanding their money back.
That reduces what investors can recoup and the fund’s net asset value (NAV), the measure of its worth, at a given time.
To counter this, Dorthe Nielsen at GAM Investment Management holds as much as 5-10 per cent of her portfolio in cash. This can prove costly but has helped her avoid a scramble to offload bonds during a sell-off.
An alternative to cash is short-tenor debt, says Pierre-Yves Bareau, head of emerging debt at JPMorgan Asset Management.
If needed, “we just decrease some cash-like bonds — six-month or one-year bonds that are quasi-cash for us,” he said.
Buying-and-holding has become more common across the industry — out of necessity, but also because of the influx of new players such as pension or sovereign wealth funds that trade less and focus more on steady income.
At Pinebridge Investments, the emerging debt team has built models to calculate what extra yield a new bond should pay to compensate for holding it for its lifetime, with a premium demanded of illiquid, low-rated credits.
“Much as you build in a credit spread to pay for credit risk we are looking for a more scientific way to put a liquidity score on individual companies and countries, to quantify how much additional premium each bond needs to pay for its relative illiquidity,” co-head of emerging debt Steve Cook said.
Electronic trading has been relatively slow to gain traction in emerging debt, the market for which is smaller and more fragmented than its developed peers, with many more countries and currencies. Thin liquidity can keep buy or sell orders on screens for hours, causing bid-offer spreads to gape wider.
MarketAxess, one of the bigger e-trade platforms, nevertheless reported a 30 per cent volume surge in 2015, even while data from industry body EMTA showed a 20 per cent year-on-year overall trading drop.
More than a 10th of MarketAxess’ emerging debt now changes hands via Open Trading, a platform that allows its 600 or so investor clients to deal direct with each other.
This bypasses the traditional request-for-quote protocol, under which investors send electronic inquiries to several dealers, then execute the deal at the best price, and gives direct access to the widest universe of trading partners.
JPMAM’s Bareau expects e-trade will take over in the next decade. In the meantime he says big funds have stepped up to get over-the-counter (OTC) trade moving by acting as market makers and buying from peers in times of volatility.
“You want to create a two-way flow. In the past it was only the banks doing that. Now real money managers are doing that a bit more,” Bareau said. “When you are the one offering liquidity to someone that really wants to get out ... you can usually make a good price out of it.” He added: “People are getting more disciplined, trying not to move as a crowd and be a bit more contrarian.”