Wall Street has done a lot of hand wringing over corporate bond market liquidity in recent months as the Federal Reserve’s expected rate liftoff approaches.
Market participants are concerned that banks holding fewer bonds on their books as result of post-crisis capital requirements, coupled with strong debt issuance in recent years could cause a liquidity crunch when rates rise and investors look to sell.
Ratings agency Standard & Poor’s took a look at which types of financial firms and funds would be hardest hit in a worst-case scenario, should investors aggressively shed their corporate fixed income holdings.
The analysts said fixed-income funds, business development companies and institutional brokers would be the hardest hit during a period of sustained bond-market illiquidity. Meanwhile, banks’ ability to handle liquidity risks is “relatively strong” and alternative asset managers and life insurers are in the best position.
They said a heavy sell-off in corporate debt markets “could certainly lead to downgrades and negative outlooks for financial entities.”
“Changes in regulations and in the fixed-income market structure in both the dealer and investor communities, as well as technological developments [such as electronic bond trading platforms], could trigger the emergence of a different set of risks in the corporate market than we’ve observed in prior cycles,” S&P analysts wrote in a report published Wednesday. “Whether such risks are likely to consist primarily of volatility spikes or are likely to generate a new type of systemic risk is difficult to ascertain.”
The agency said it does not typically factor illiquidity in the corporate-bond market into its ratings expectations or outlook.
“The idea was to lay out our thinking at a sector level: What are the structural characteristics that make some sectors more vulnerable than others and what capacity do these entities have to handle a market liquidity scenario,” said Devi Aurora, senior director at S&P.
Aurora added that the agency was not drawing conclusions about what is likely to play out in the market. “At this point it’s very hard to say a priori if it will result in systemic risk,” she said.
S&P’s note comes as global authorities study whether the asset management industry poses systemic risks. Last week one of two key watchdogs that had been considering systemically important financial institution designations for asset managers and the funds they manage pressed pause in favor of a broader look at products and activities in the sector.
Asset managers have lobbied hard to avoid firm or fund-level designations.
Famed investor Bill Gross weighed in on the potential challenges funds may face meeting heavy redemptions in the event of a major macro-economic event in his most recent investor letter. He highlighted post-crisis changes in market structure – including the growth of the so-called “shadow banking system” and warned: “Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.”
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