Investors should be cautious about fixed income too

FIXED income assets are traditionally seen as staid, low-risk investments, a counterbalance against equity volatility. In recent years, Asian investors have embraced bonds. This is partly because the yields earned are typically much higher than the prevailing near-zero deposit rates, and partly because bonds are a welcome oasis amid market instability.

Thus far, the experience has been rewarding not just for the income but also for capital values that have continued to appreciate, confounding naysayers. But investors, particularly individuals, should tread with caution. Quite apart from the impending interest rate hike by the US Federal Reserve and the recent phenomenon of negative interest rates in Europe, a number of structural changes in the marketplace have significantly affected the liquidity of bonds, particularly corporate bonds. This suggests that some serious risks may lurk - even for those who invest through supposedly liquid mutual funds and exchange-traded funds.

Concern is rising to the extent that the Bank of International Settlements in March sounded a warning that liquidity is "concentrating in the most liquid securities, while conditions are deteriorating in the less liquid ones". There are a number reasons for the dearth of liquidity. One is that banks have largely ceased to act as market makers for bond trades, as regulatory capital requirements have made it onerous for them to take the securities onto their balance sheets. While the regulations were meant to forestall a financial crisis post-2008, they are wielding a significant impact on the bond market. Another change is the ratcheting downwards of risk appetite, which leads institutions that continue to act as market makers to hold even less inventory of bonds. Data shows that outstanding corporate issuance has climbed steadily for more than a decade, but US dealers' inventory has plunged since 2007.