As we have noted in the past, liquidity in the fixed-income markets has been decreasing for several years due to increasing financial regulations. A primary reason for this is that banks, brokers, and other market makers only hold a fraction of the bond inventory that they used to. Fixed-income risk has been moved from bank balance sheets to asset managers, such as mutual funds and exchange-traded funds (ETFs).
This new environment comes with both challenges and opportunities. On the one hand, reduced liquidity will lead to more volatility. On the other hand, well-positioned investors can exploit the inefficiencies that illiquidity brings. Consider the below example:
Suppose there is volatility in the financial markets and bids (buyers) disappear. If you need to sell an asset in an illiquid market, then you have a problem. But if you have the ability to buy from forced sellers in an illiquid market, then you have a real opportunity. The difference is whether you have to sell or you have the ability to buy. In illiquid markets, we want to be a provider of liquidity so that we can dictate the price.
Recently, there has been increased interest in whether asset managers are at risk of fire-sales and runs. Large fund companies such as Vanguard, BlackRock, and PIMCO argue that they are not at risk for a variety of reasons. Yet, we have seen liquidity stresses build up and bring down large funds that are imprudently positioned. We spend a lot of time assessing whether the funds we use are at risk, not at risk, or can capitalize on those risks. We think that the illiquidity in the bond market will continue, which presents both risks and opportunities that must be carefully navigated.