NEW YORK--(BUSINESS WIRE)--Asset managers are planning to hold more cash and large liquid bonds as broker/dealers' importance in providing liquidity to the fixed income markets has diminished, according to a Fitch Ratings survey of major asset managers. The changes are a natural offshoot of banking regulations that have reduced broker/dealer inventories of corporate and municipal bonds.
Broker/dealer inventories are down $250 billion for corporate bonds and $32 billion for municipal bonds (a 65% reduction in both cases) since year-end 2007, according Federal Reserve data. This is not surprising given the raft of banking regulations that are indirectly impacting fixed-income markets. The Volcker Rule particularly restricts proprietary trading by banks and affiliated broker/dealers. The Basel III liquidity capital ratio and net stable funding ratio make it more costly to hold inventories of securities. As a result, the importance of broker/dealers in the fixed-income markets has clearly diminished.
Click here to view related chart.
It appears that asset managers have partly stepped in to fill this void. Ownership of corporate bonds by mutual funds has grown by $1,458 billion, or 149%, since year-end 2007, and now represents 21% of total outstanding. Holdings of municipal bonds grew by $264 billion, or 57%, since year-end 2007, and now represent 20% of total outstanding.
However, Fitch's survey found that asset managers are increasingly focused on larger and more liquid issues that can be quickly sold off in market stress. This means liquidity and price volatility for smaller, off-the-run issues may be disproportionately impacted by recent market changes. Moreover, allocation changes and/or investor redemptions from larger funds are likely to play a more significant role in bond market liquidity in the future.
Fitch also found that asset managers are holding higher portfolio cash balances to meet investor redemptions upon demand, in effect offsetting structural declines in dealer inventories and market liquidity by holding additional internal liquidity. This may ameliorate some of the aforementioned impact on market liquidity, but holding more cash will act as a drag on performance. Fund managers also reported avoiding smaller counterparties who may not be as able to back up their trades.
Insurance companies have also added to their holdings of fixed-income securities, similar to asset managers. Insurance companies added $533 billion of corporate bonds and $61 billion of municipal bonds to their portfolios since year-end 2007 (increases of 25% and 15%, respectively). Similarly, pension and government retirement funds added $326 billion of corporate bonds, now representing 9% of total outstanding. Since both are normally buy-and-hold investors, this shift in ownership may help stabilize bond prices in a future stress while offsetting the pullback by banks and the growing role of asset managers.
Market commentary has focused on the pullback by banks and how the changing market dynamics could increase bond-price volatility in future stress scenarios. In recent years, bond markets have exhibited bouts of volatility; for example, the "taper tantrum" of 2013. Just last month, bond prices fell on the news that Bill Gross would depart from PIMCO, eliciting much commentary. However, the net effect of the changing mix of investors remains to be seen.
Bond liquidity and volatility are essential to understanding the risk of market value structures, such as in closed-end funds that pledge assets to collateralize debt and preferred stock leverage. In rating such structures, Fitch applies a worst-loss methodology to determine the minimum asset "haircuts" needed to withstand future prices declines. Fitch regularly reviews these haircuts and, so far, believes they are both appropriate and take into consideration the changing market dynamics for bond liquidity.
Opt-in to receive Fitch's forthcoming research on closed-end funds:
http://pages.fitchemail.fitchratings.com/FAMCEFBlankOptin/
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.