On the face of it, high-rated bond markets remain the safest haven of all. Demand for government-backed debt seems insatiable, with yields on short-maturity bonds issued by seven of the G10 grouping of developed nations (Germany, Japan, France, Belgium, the Netherlands, Sweden and Switzerland) in negative territory in recent weeks.
Negative yields mean investors are paying for the privilege to own government IOUs. In the other G10 debt markets (the US, UK, Canada and Italy) short-dated yields are near zero and at record lows.
And, on average, the cost of dealing in government bonds remains minimal.
Data compiled for FTfm by Tradeweb, an electronic bond trading hub, show that during the past three years the typical bid-offer spread for 10-year UK gilts has contracted from around 7 pence per £100 in nominal value to around 3-4 pence, with a similar reduction seen in German Bunds.
For US Treasuries, the textbook “haven” asset class, 10-year bid-offer spreads have averaged 0.1 to 0.15 basis points in yield throughout the three-year period, says Tradeweb.
But the headline data belie increasing nervousness among a wide range of market participants about the resilience of government bond markets.
On October 15 2014, during a sharp rally in bond prices, market depth in US Treasuries suddenly contracted to a fraction of its previous level and several market makers shut down their electronic trading systems.
According to Nanex, a research firm, while Treasury trading volumes hit a record on October 15, the depth of both sides of the trading book contracted by more than 80 per cent during the first two hours of US trading.
Nanex labels the October 15 move in Treasuries as a “flash crash”, drawing a parallel with the 1,000-point, algorithm-driven intraday move in the Dow Jones Industrial Average of US equities in 2010.
Some market participants play down any suggestion of fragility in government bond markets.
“On October 15 we printed trades at each and every price point on the move up and the move down in Treasuries. We saw no gapping in prices and had record turnover,” the operator of one interdealer trading platform told FTfm, speaking on condition of anonymity.
But governments and regulators are taking nothing for granted. The US Treasury Borrowing Advisory Committee, a grouping of banks, hedge funds and investment houses, said late last year that it had discussed the possibility of electronic algorithms exacerbating price changes in US government debt.
“The risk of future flash price adjustments exists and needs to be better understood,” committee members said in the report they sent to Jack Lew, the US Treasury secretary.
In a consultation document published in October 2014 to launch its Fair and Effective Markets Review, the Bank of England noted that the decreasing capacity of banks to hold inventories is likely to have an impact on the liquidity of the bond and foreign exchange markets.
The “electronification” of market making in fixed income and currency may increase transparency in normal market conditions, the Bank observed, but in unsettled markets the shift away from the traditional bank-centred dealing model may go hand-in-hand with a drop in liquidity.
Banks’ ability to stabilise pricing in the bond markets via the use of their balance sheets to hold inventory is also now a thing of the past, according to an analyst of the fixed income market’s structure.
“In the old days there was an information asymmetry between the broker-dealers and the rest of the market. The brokers could absorb large transactions without moving prices. Now the brokers have stepped back, it is possible to move markets with a smaller-sized order,” says Rajeev Ranjan, lead technical expert in the financial markets group at the Federal Reserve Bank of Chicago.
“Bid-offer spreads in Treasuries have tightened and volumes have gone up. But tighter spreads and higher volumes do not by themselves constitute liquidity. You have to look at the depth and resilience of the trading book,” says Mr Ranjan.
Richie Prager, head of global trading at BlackRock, the world’s largest asset manager, foresees more events in the fixed income markets akin to October’s intraday move.
“The mini flash crash in Treasuries was a glimpse of what the world will look like,” he says.
“With the reduction of principal-based market making, we are going to see more episodes of discontinuous market pricing. This kind of behaviour is inherent in a highly electronic, agency market structure.”
A recent shift in the investor base for bonds could also exacerbate market volatility, argues Andy Burgess, product specialist at Insight Investment, the asset manager owned by BNY Mellon, in London.
“The greater involvement of retail investors in fixed income via pooled funds and exchange traded funds means a less stable investor base, one that is more prone to swings in sentiment,” says Mr Burgess.
Standard retail bond funds in the US and Europe offer a daily redemption window to their holders. The market prices of ETFs, a subcategory of this type of fund, change continuously throughout the trading day to reflect changes in the value of their holdings.
Fixed income ETFs attracted a record $79bn in inflows globally last year, according to BlackRock.
ETF issuers argue that their product is a stabilising, rather than a potentially disruptive, force in the bond markets.
“Bond ETFs help to consolidate liquidity by allowing a single trade in hundreds or thousands of underlying bonds. They also help to move market making away from a capital-intensive, principal-based model towards an exchange-based one with a single order book,” says John Hollyer, principal and head of risk management at Vanguard, the asset manager.
Steve Meier, chief investment officer of fixed income at State Street Global Advisors, adds: “ETFs are having a positive impact on liquidity, particularly in distressed markets. We have noticed ETF trade volumes rising when corporate bond credit spreads have widened.”
Given the relative withdrawal of banks from the bond markets and the increasing size of the funds they control, asset managers are keen to stress the implications of their new role as price makers.
“A lot of what we think about internally is how we should communicate these changing liquidity dynamics to our clients,” says Mr Meier. “If your mandate allows it, it is better to be an opportunistic buyer in stressed markets than to overreact to price moves and become a forced seller.”