As Credit Market Liquidity Suffers, Institutional Investors Seek Alternatives

U.S. institutional fixed-income investors struggling with recent reductions in credit market liquidity are seeking relief in derivative products, but finding they are a less-than-perfect solution. A new report, The Great Transformation: A Credit Liquidity Story, from Greenwich Associates suggests that while liquidity in the corporate bond market will never return to its pre-crisis state, market structure changes and product innovation will provide investors with improved access to credit market exposure.

Eighty-five percent of the 1,027 U.S. institutions participating in Greenwich Associates 2013 U.S. Fixed-Income Investors Study are concerned about the loss of liquidity in credit markets. And when the market eventually shifts from risk-on to risk-off, credit market liquidity will only get worse.  According to the new report, the root cause of the most recent liquidity reductions is not a lack of supply of credit investments, but rather, market structure transitions impeding the market’s ability to put risk in the hands of those who want it most.

Index Credit Default Swaps

On the surface, single-name CDS would serve as the most direct proxy for cash bonds – but they suffer from a different set of liquidity problems. While supply is theoretically unlimited because contracts can be created at will, natural demand impacted by regulatory uncertainty continues to be limited. As a result, dealers keep spreads wide to offset their hedging costs. Wide spreads translate into high prices, which further limit client demand and perpetuate low liquidity in the product.

Index CDS are well suited to futures-style, anonymous, electronic trading, which has helped their surge in popularity. In 2013 cash bonds represented 65% of buy side credit trading, a huge drop from 77% in 2012. CDS indexes, on the other hand, have moved in the opposite direction, with investment-grade index derivative trading by investment firms jumping from 14% in 2012 to 22% of trading in 2013.

“There is one major drawback to the use of index CDS, however,” says Kevin McPartland, head of the market structure and technology advisory practice at Greenwich Associates. “As the use of CDS index products has increased, the correlation between the index and its constituents has partially broken down. The lower correlation allows basis risk to creep in if an investor uses the index as a substitute for a single credit.”

Looking Ahead: Fixed Income ETFs and SEFs

Enter fixed income ETFs and their derivatives. To be fair, ETFs can also suffer from liquidity problems, and many see them as a retail-driven product. But if the success of existing fixed-income ETFs is any indication, their liquidity is moving in the right direction.

Looking beyond the liquidity potential of alternative credit products, new swap execution facility (SEF) rules will allow the creation of liquidity pools suited to investors both large and small. The resulting market will be a bifurcated one, but this will ultimately benefit credit markets as a whole as like-minded buyers and sellers will gravitate towards the most suitable SEF. “Despite the potential for bifurcation, this evolution will help liquidity rather than hurt it,” says Kevin McPartland.  Credit markets allow the global economy to function, which means the market has no choice but to find methods of transferring credit exposure.

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