Poor liquidity in bond markets poses threat to investors, experts warn

Bond managers are facing an “intense lack of liquidity in corporate bond markets”, meaning that they could be in a dangerous situation when it comes to high-yield investments, experts have warned.

Tom Becket, chief investment officer at Psigma Investment, has claimed that a reversal in sentiment could send shockwaves through markets that could affect equities, adding that the “huge appetite” that still exists for bonds may continue to support markets  for the time being, but that it would be wise to “get out before the party ends”. He warned that the poor liquidity of markets could cause real problems for managers who do not get out in time.

The warning comes after US Federal Reserve chairman Janet Yellen announced last week that valuations on “lower-rated corporate debt” are beginning to become “stretched”.

Joining Becket, Morningstar OBSR investment strategist Andy Brunner said Mr Brunner said investors need to question whether they are being compensated for the “substantial liquidity risk” in holding corporate bonds.

Mr Brunner concluded that most market participants are now “hugely overweight an asset where the potential for excess returns has declined significantly and where liquidity is a major issue”.

He said that, on a six-month view, “credit will likely continue to outperform, led by riskier corporates” as the fundamentals still appear attractive, but he pointed out that the fundamentals “appeared” to be attractive in 2006-07 as well.

Daniel Lockyer, senior fund manager at Hawksmoor Investment Management, said the risk/reward outlook for high-yield bonds is becoming increasingly skewed to the downside.

He said that even the best-case scenario would only see the asset class grind slightly higher in the next year, adding that he “[does] not see the value in hanging on for just a couple of percentage points when the downside outweighs that potential benefit”.

Nick Hayes, manager of the Axa WF Global Strategic Bonds fund, said the bond market is now pricing in an “exceptional economic recovery”, predicting that bond prices will fall when people become disappointed with a more modest recovery. He said bonds are likely to keep rising in the short term and that investors will continue to favour lower-rated debt in spite of Ms Yellen’s warning, but added he has been reducing his exposure to high-yield and emerging market debt.