Long time readers of our Market Digest know that we have been concerned about
liquidity in the bond markets for a while. Liquidity is simply a term that refers to the capacity to trade securities without significantly affecting the price. To combat the global financial crisis of 2007-08, central banks around the world supported bond markets through massive injections of capital. But as the Federal Reserve has begun to reduce its $4.5 trillion bond portfolio and the European Central Bank trims its own bond-buying program, bond securities around the world have become harder to trade.
Bid-Ask Spread
The "Bid-Ask" is a term used to describe the difference in the price a trader is willing to sell and the offering price at which a second trader is willing to buy. It's also a useful way to monitor bond liquidity - the smaller the spread between the ask and the bid prices, the more liquid the market is considered.
According to data from MarketAxess, the median bid-ask spread across European corporate debt and emerging-market bonds has widened. This is visible in the chart below (Note EMEA refers to Europe, Middle East and Africa).
Recent episodes of extreme stress in Italian bond markets serve as a reminder to bond investors that liquidity levels can change rapidly and that as fiscal stimulus
recedes
, bond markets are more vulnerable to shocks. After Italy's President vetoed a populist alliance's choice of finance minister, Italian bond yields soared (2-year bond yields rose 1.57% and the 10-year bond yields rose 3.1% in just two days). Remember, prices and yields move in opposite directions; as these yields rose, prices were falling.
How Does This Impact Your Portfolio?
Parts of the global bond market have always had patches of illiquid trading, especially during bouts of financial-market turbulence such as what Italy experienced in the early part of summer.
It's important to understand that during real high-risk events, no one is able to trade. And this doesn't just apply to bonds in far off places. It can happen in the US and it can happen to exchange traded funds (ETFs) which are commonly thought of as being extremely liquid. But ETFs are only as liquid as their underlying securities and when crisis hits, their bid-ask spread will increase just like any other bond instrument.
The best protection for your portfolio is to utilize the services of an active bond manager. They have the flexibility to position portfolios according to market conditions and should be less likely to get trapped by forced selling at fire-sale prices during times of financial stress.