A dangerous consensus

At the height of the financial crisis, credit markets seized up and liquidity disappeared. In the aftermath of Lehman’s bankruptcy, this caused huge headaches for investors, institutions, and regulators. It may surprise you to learn then, that turnover in these markets is lower today than it was at the nadir of the crisis. So, what’s going on?

Gopi Karunakaran, Portfolio Manager at Ardea Investment Management, explains that banks have withdrawn from corporate bond markets due to regulatory changes, which has created a significant unseen risk. “As yields have gone lower, defensive fixed income portfolios have had to buy more and more credit in order to keep returns up. I think that is a very dangerous consensus trade.”

In the full video below, he explains what this means for the US$560 billion in fixed income ETFs around the world.

Key points: 

• An unseen risk has been building in corporate bond markets in recent years
• Historically, investment grade corporate bonds have been a relatively safe and liquid asset class
• Changes in the way banks are regulated have reduced their ability to trade in corporate bond markets, massively reducing liquidity in the secondary market
• Turnover as a percentage of the total market is lower now than at the worst point of the financial crisis
• ETFs offer instant liquidity, however, the underlying corporate bond market is increasingly illiquid
• If the bull market in bonds starts to turn, the liquidity of these ETFs could be tested. 

Ardea Investment Management is a specialist fixed income investment boutique with a focus on delivering consistent alpha to clients through an investment process supported by a highly intuitive risk system. For further information please click here