By Jonathan Platt
Is credit market liquidity improving or deteriorating? And why this is the wrong question.
Credit markets have been very volatile over the last six years, with investment grade spreads widening from 0.5% prior to the financial crisis to 4.5%, before falling to 1.5% now. We believe this still significantly over-compensates investors for holding credit risk and expect spreads to decline further (although not to pre-crisis levels) reflecting structural changes and psychological factors.
One factor often cited for the relative undervaluation of credit is liquidity – higher transaction costs and lower dealing sizes relative to government securities. UK and European credit markets have grown very strongly over the last two decades, reflecting low absolute interest rates, the desire for long term finance, the maturing of pension funds (and the demand to obtain long term cashflows offered by credit bonds) and, more recently, the deleveraging of bank balance sheets (as capital markets have partially replaced bank funding).
A decade ago some commentators expected credit market characteristics to mirror those of equity markets – high liquidity, greater price transparency and active derivative markets – although the evolution of credit markets has been patchy, partly reflecting the differences between the two. Credit investors tend to be risk averse and focus on what can go wrong; equity investors are more interested in long-term growth opportunities and what can go right. Small changes in investor sentiment can therefore have disproportionately large impacts on relative valuations of credit. At times markets lose their ‘two-way’ status, with the majority of investors all looking to execute the same trade; this can make trading bonds very difficult and expensive.
These structural impediments on liquidity have recently been exacerbated by banks facing pressure to boost capital ratios and withdrawing resource from their credit trading businesses. There is increasing evidence that credit markets are bifurcating, with liquidity being concentrated in the largest issues and the rest experiencing lower price transparency and liquidity. This process is self-reinforcing as large asset managers, coping with high cashflows, and momentum-based trading funds are forced to buy the largest issues. Increasingly many managers are chasing the same liquid bonds, forcing credit spreads on those issues ever tighter.
Whilst this may sound like a recipe for buying only liquid bonds, we would argue firmly that the reverse is the case. With large swathes of credit bonds being overlooked, a significant valuation gap is opening up between the large liquid issues and those bonds which trade less frequently and where patience is required to source. For long-term investors, this presents a real opportunity: valuations are more attractive, they can offer greater economic/ sector diversity and they often have particularly attractive features such as enhanced security and better covenants.
We believe that by targeting our expertise on these overlooked areas of credit markets we can offer our clients a better risk/return trade-off, with attractive cashflows across a diversified range of bonds. This strategy may not appeal to investors looking for quick moves in and out of credit but, in truth, a credit approach that was reliant on the ability to generate value through short-term trading, whilst always low conviction, is now becoming increasingly ineffective in the new credit landscape.
Jonathan Platt is head of fixed interest at Royal London Asset Management
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