THE problem of too little supply relative to demand in the UK corporate bond market is being felt directly by investors. This is because investment banks have cut their exposure to corporate bond market-making, leading to illiquidity in the asset class.
The fundamental supply/demand problem reflects a lack of issuance by large companies that are, generally, currently cash-rich.
Meanwhile, on the demand side, investor enthusiasm for yield has led to large funds becoming still larger.
But this would not be a problem for investors if market makers could offer liquidity.
In their absence, a few very large funds have effectively become forced buyers of any direct underlying bond holdings they can find and of an increasingly varied array of assets.
Two main factors have led to banks decreasing their exposure to corporate bond market making: first, it is part of a current trend by banks to reduce exposure to risk activities.
Second, market making is capital-intensive, requiring banks to go long or short on the names they create a market for.
Banks don’t have the capital to do this any longer, and if they do they are inhibited by new regulations as to what they may do with it and how they calculate the risk involved.
The liquidity issue works in favour of smaller funds in the sector.
They are able to be more selective over what they buy, and are not forced into overcrowded or more exotic parts of the market.
So what are the consequences for investors?
As long as the major central banks keep interest rates at very low levels there is no reason to fear a rise in bond yields (which would lead to a fall in corporate bond prices).
Meanwhile, investors seeking an income that will beat inflation will continue to look to the corporate bond sector for solutions. However, the problem of liquidity is unlikely to go away in the near term. This in turn discriminates disproportionately against the large funds.
• Tom Elliott is global strategist at JP Morgan Asset Management
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