Bond liquidity issue beginning to leak

A new study repeats Ian Russell's recent warning on new dynamic in bond market.

A week ago WP posted comments following an interview with the head of the Investment Industry Association of Canada, Ian Russell. At the time Russell warned of the decreasing trading action in bond markets.

As Russell explained then, new regulations and record low interest rates have conspired to chase traders from the bond market. Liquidity is drying up. Market volatility could be amplified. The worrying consequence: bond holders could have problems trading out of markets easily as there are no buyers to facilitate the move. Considering how heavily the mass herd is invested in bonds these days, chaos could ensue, or so claimed Russell at the time.

A week later a new report arrives from the Royal Bank of Scotland making precisely the same points. 

According to the new report, liquidity in the bond market is drying up. Market makers are disappearing as new regulations and ultra-low interest rates make it unprofitable to take the risk of trading in bonds. The report claims liquidity has declined by about 70 percent since the financial crisis, suggests the lack of liquidity poses a threat to the stability of the financial system and states that regulators are ignoring the issue.

Money managers will want to consider the potential consequences. What happens if investors begin to move out of bonds? With fewer traders in the market, the “door” to exit the bond market is smaller. If, at some point the economy recovers, the Fed winds down stimulus efforts, and interest rates rise, the mighty herd could find it difficult to move out of the market. Could current bond holders get stuck holding a bag full of fixed-income securities plunging in price? This seems to be the conclusion.

The report warns money managers to stay away from bonds in which "individuals, mutual funds and exchange traded funds" are the main investors. According to RBS these were the areas of the market that experienced the biggest sell-off the last time the Fed last tried to taper stimulus efforts.