Liquidity Decline in Global Fixed-Income Markets is Here to Stay

Regulatory Mandates and Changing Trading Practices Create Short-Term Challenges as well as Opportunities for Long-Term Investors

Aug 03, 2015, 09:00 ET from Legg Mason, Inc.

PASADENA, Calif., Aug. 3, 2015 /PRNewswire/ -- Global fixed-income markets are experiencing a significant decline of liquidity. This can impact the ability of professional asset managers to facilitate the purchase or sale of an asset without causing a change in the asset's price.

While some market watchers find this troubling, Western Asset Management Deputy Chief Investment Officer Michael C. Buchanan considers it a normal evolution of fixed-income markets that can create opportunity for long-term investors.

"Regulations have had some unintended consequences, one of which is reduced liquidity in fixed-income markets," Mr. Buchanan said in a recently released Western Asset Q&A. "Global investment bank trading desks have experienced a dramatic reduction in the amount of capital they are able to commit to trading fixed-income securities today. This is primarily due to these firms making the determination that, given new bank capital requirements, it is not an efficient use of capital to inventory the amount of bonds they held prior to the financial crisis."

"As a result, liquidity across all fixed-income asset classes is less than what managers such as Western Asset enjoyed pre-crisis."

Regulatory changes are the primary cause of declining liquidity, in Western Asset's view.

"Various bank regulatory reforms — most notably Basel III, Dodd-Frank/Volcker Rule legislation — and other market regulatory modifications have improved bank transparency, bolstered bank capital and improved bank liquidity, all necessary improvements designed to reduce the possibility of another financial crisis," Mr. Buchanan explained.

"However, they have also had the unintended consequence of reducing the ability to buy and sell bonds without affecting the asset's price." This essentially defines "lower market liquidity."

The full Western Asset Q&A, Liquidity in the Fixed-Income Market, can be accessed on the Western Asset website.

While troubling to some market participants, the evolving situation can also create opportunity.

"In an effort to optimize the use of what capital sell-side firms have, most have implemented practices that concentrate their efforts on those clients deemed integral to their capital markets business," Mr. Buchanan observed. "These clients are typically the largest money managers by asset under management ("AUM"), of which Western Asset is one. While liquidity remains a challenge for market participants, Western Asset certainly benefits from being in a highly select group of managers that broker/dealers view as high priority."

"For those institutional investors whose investment manager's investment style is predicated on frequent trading strategies to generate more than a marginal amount of performance, they are likely to experience challenges going forward. Alternatively, managers whose investment style is based on taking a long-term approach supported by disciplined fundamental research should benefit from the increase in liquidity premiums currently in the market."

All fixed-income sectors are impacted, but in Mr. Buchanan's analysis some bear a larger brunt.

"The further you move out the risk spectrum the larger the decline in liquidity," he reported. "High-yield, bank loan and emerging market (EM) sectors have experienced the greatest declines, while the declines in US Treasuries (USTs) and agency MBS sectors have been less apparent. Other developed governments and investment-grade credit fall somewhere in between."

As a result, Western Asset has adopted steps to maintain sufficient levels of liquidity.

"We manage a wide variety of portfolios against many different benchmarks (in the case of separately managed institutional portfolios) or peer groups (in the case of retail mutual funds)," Mr. Buchanan said. "Regardless of whether a portfolio experiences daily inflows or outflows (i.e., mutual funds) or not (i.e., institutional separate accounts) we maintain a level of liquidity that is measured by risk management on a regular basis."

"Maintaining portfolio liquidity for mutual funds is of significant importance, and as such, we have been increasing the use of instruments such as cash, T-Bills, ETFs and derivatives to provide additional liquidity."

Western Asset's Risk Management Team has developed a proprietary model to measure liquidity under stress.

"The model's methodology starts with repo haircut levels based on studies published by the Federal Reserve Bank of New York and the International Capital Markets Association," Mr. Buchanan said. "Western Asset's trading desks provided further criteria to classify securities not covered by repo haircuts. The model makes various adjustments to the scale based on characteristics such as issued amounts, bond age, years to maturity, and the number of contributed pricing sources."

"All these factors are then brought together to provide a liquidity level from 1 to 5 for each security, with 1 being the most liquid and 5 being the least liquid. The sum of the total market value in each liquidity bucket is compared between a portfolio and its benchmark."

While challenging in its permutations, Mr. Buchanan believes the regulations will accomplish their objectives of ensuring more stable markets. The markets will adjust – as they always do.

"While it's certainly a concern, we don't think we are likely to see a significant liquidity-related crash given the supportive fundamental backdrop existing in the market today," Mr. Buchanan observed. "So while liquidity has declined, our belief as of now is there is sufficient liquidity to transact in the market and execute strategies across all fixed-income asset classes."

About Michael C. Buchanan, CFA
Mike Buchanan is Deputy Chief Investment Officer of Western Asset Management, a post he assumed in March 2015. Formerly Western Asset's Head of Global Credit, he joined the firm in 2005. Mr. Buchanan previously served as managing director and head of U.S. credit products at Credit Suisse Asset Management; executive vice president and portfolio manager at Janus Capital Management; managing director and portfolio manager at BlackRock Financial Management; and vice president and portfolio manager at Conseco Capital Management. A Chartered Financial Analyst, Mr. Buchanan graduated with a B.A. from Brown University.

About Western Asset Management
Western Asset Management is one of the world's leading fixed-income managers with $453 billion in assets under management as of June 30, 2015. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, Sao Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more, please visit www.westernasset.com.

About Legg Mason
Legg Mason is a global asset management firm with $699 billion in assets under management as of June 30, 2015. The company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

All investments involve risk, including loss of principal. Past performance is no guarantee of future results. Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities. Derivatives, such as options and futures, which can be illiquid, may disproportionately increase losses, and have a potentially large impact on performance. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Asset-backed, mortgage- backed or mortgage-related securities are subject to prepayment and extension risks. Risks of high-yield securities include greater price volatility, illiquidity and possibility of default.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity.

The views expressed are as of the date indicated and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision.

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