Flexibility is key in illiquid market

A significant secular change impacting investment decisions in the bond markets is the tightening regulatory environment that is creating a climate of reduced liquidity. This represents a tectonic shift in the investment landscape as we have known it for the past three decades, and not solely for asset valuations but also for those who manage assets in this environment.

In recent years we have witnessed an onslaught of financial regulation intended to prevent a repeat of events that led to the financial crisis. While these regulations seem reasonable and rational in the wake of the crisis, what must not be overlooked is the broader market impact that these regulations have had on providers of liquidity. This in turn impacts asset managers who are takers of liquidity, especially those with the largest assets under management (AUM).

Policy makers have endeavoured to make the financial system safer by introducing many regulatory changes. These include moves to disincentivise banks from providing cheap leverage and liquidity to investors with a short investment time horizon, the so-called 'fast-money' community who rely on this easy access to capital. Increased capital charges have led banks to reduce their inventories, especially for credit instruments and high risk-weighted assets that are less liquid.