Everyone from Blackstone CEO Steve Schwarzman to JP Morgan’s Jamie Dimon has warned about the looming crisis in the bond markets. But according to some money managers, it could create a huge opportunity.
The concern over bond-market liquidity stems from the financial crisis. After the collapse of firms such as Lehman Brothers, new rules were implemented, limiting how much risk large financial institutions were able to take on.
That led to a drop-off in so-called bond inventories, or the value of bonds held by banks to help make markets. In turn, that raised concerns that large institutions wouldn’tbe able to trade in the event of a sell-off, sending bond prices tumbling further than they otherwise would have.
According to Brian Tomlinson of Allianz Global Investors, this has made the market jittery.
“The declining liquidity in the bond markets has been a hot topic for a few years, creating air pockets and making prices vanish as volatility increases…with a frequency that is marking a turning point in markets’ history,” Tomlinson wrote Monday. “Indeed we seem to have entered a new, turbulent era: the era of volatility 2.0”
According to Tomlinson, one needs to go back just a few months to see how this shift has changed the markets.
“The volatility of volatility as shown on the above graph has been steadily rising since 2008….even if events are less “earth moving” relative to other historical events,” said Tomlinson. “Indeed, the recent Fed/China events have triggered a much stronger reaction than the Lehman Brothers collapse…which can look out of proportion.”
Michael Buchanan, a deputy chief investment officer at Western Asset Management, said during a company podcast that this new illiquidity-created volatility is an opportunity for bigger investors.
“The decline in liquidity we have seen has certainly made markets less efficient,” he said. “Because of this inefficiency, securities often have departed further from their intrinsic value, thereby creating great opportunities for value-oriented investors.”
To Buchanan, the market is so concerned by the illiquidity issue, it is helping boost their investments.
“This is a real unique opportunity that, through superior fundamental research, we can continue to identify companies that have great management teams, great business profiles and prospects, and ultimately get paid more for those particular issues,” he said.
“We’re demanding a greater illiquidity premium, but we’re still getting the same kind of investments.”
Tomlinson came to this same conclusion in his post.
“What happens to fixed income markets when a new peak of volatility arises? The flight to safety makes government bond prices surge, while corporate and emerging market bond prices get cheaper,” he wrote.
“We fund managers can then buy these cheaper assets by selling our ‘liquidity buckets’ (i.e. cash or liquid government bonds).”
So, essentially, these large institutional investors are able to take advantage of other investors’ fears about the bond market and end up making big gains.
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