Douglas Peebles 

Chief Investment Officer—Fixed Income

Ashish Shah

Head of Fixed Income

THE BOND LIQUIDITY CRUNCH

AND WHAT TO DO ABOUT IT

PLAYING WITH FIRE

IN THIS PAPER: Bond investors are used to managing interest-rate and credit risk. These days, they’re 

spending a great deal of time worrying about liquidity risk. There’s good reason for their concern. Global 

bond market liquidity is drying up at a time when many investors around the world may need it most. 

However, investors can turn less liquid conditions to their advantage. In this paper, we’ll explain what’s 

behind the liquidity drought and what investors can do to protect themselves and, potentially, profit.

MARCH 2016
DISPLAY 1: TRADING NOT KEEPING PACE WITH MARKET GROWTH

Trading Volume, Market Size and Turnover

 Volume Traded  Market Size  Turnover (Right Scale)

05 06 07 08 09 10 11 12 13 14

05 06 07 08 09 10 11 12 13 14

0

1,000

3,000

2,000

5,000

4,000

6,000

200

0

400

600

1,000

800

1,400

1,200

1,600

USD Billions

Percent Percent

USD Billions

80

100

120

140

160

180

200

60

65

70

75

80

85

90

95

100

105

Investment Grade

High Yield

Historical analysis does not guarantee future results.

Through December 31, 2014

Source: Barclays and AB

THE LIQUIDITY CRUNCH

AND WHAT TO DO ABOUT IT

Professional bond investors tend to be a gloomy bunch. Even at the best of 

times, they can rattle off at least half a dozen things to worry about. But if 

you ask what’s keeping them awake at night now, you’re likely to get just one 

answer: liquidity.

What’s draining liquidity from the market? Most investors blame changes in 

global regulations. New rules designed to make banks safer have also made 

them less willing to take risks. As a result, they aren’t big buyers and sellers of 

corporate bonds anymore. This has made it harder for investors to trade large 

blocks of bonds—and it’s making them worried that they may have to take big 

losses if they need to sell assets in a hurry.
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 1

We agree that low liquidity is a risk—but by focusing on regulations, 

we think most investors are underestimating the gravity of that risk. 

While new regulations have contributed to the problem, there are several less obvious causes that have the potential to make the liquidity 

crunch worse.

Some stem from global central bank policies (see “Central Bank 

Liquidity,” page 3): easy money has driven government bond yields 

to record lows and forced yield-hungry small investors to crowd 

into the same trades. Another driver is caution by large institutional 

investors, who are less and less willing to take the long view in bonds 

and ride out short-term market volatility.

While regulatory changes have reduced the supply of liquidity, these 

trends have drastically increased the potential demand for it. None 

on its own is likely to trigger a major market crisis. But taken together, 

they’re creating a lot of dry tinder. And the next shock to hit markets—

that prompts everyone to sell—might be the spark that sets everything ablaze. With volatility in fixed-income markets rising, investors 

can’t afford to take this risk lightly.

Fortunately, there are ways to manage liquidity risk. Investors that 

do a good job of it may even find bargains in less liquid markets—

especially if they have the luxury of large balance sheets and long 

investment horizons. In this paper, we will examine what investors 

can do to protect their portfolios. We’ll also look at what they should 

expect of their asset managers. After all, managers who don’t see the 

big picture when it comes to liquidity probably won’t be able to keep 

their clients from getting snared in a liquidity trap.

But first, let’s take a closer look at what we believe is draining liquidity 

from the system.

REGULATION: WALL STREET RETREATS

Anyone who buys and sells bonds for a living has noticed that it’s 

harder than it used to be. That’s not because the global bond market 

is shrinking. In fact, it’s growing. Companies have been on a borrowing binge, thanks to record-low interest rates. And investors are still 

lining up to buy new corporate debt.

The problems start after new bonds are issued. Over the past few 

years, investors have found it tougher to trade large blocks of bonds 

without significantly affecting their prices. To put it another way, 

trading on the secondary market, where bonds change hands after 

they’ve been issued, hasn’t kept pace with overall market growth 

(Display 1, previous page).

This is where those stricter banking regulations come in. In the past, 

banks held vast inventories of corporate bonds and traded them regularly, making a profit for themselves and making a market for other 

investors. This kept price fluctuations in check and was especially 

valuable in times of stress, as investors could count on the banks to 

play the part of willing buyer when everyone else wanted to sell. 

DISPLAY 2: REGULATIONS HURTING THE ABILITY TO TRADE

Growth of Market vs. Dealer Balance Sheets

20

60

100

140

180

05 06 07 08 09 10 11 12 13 14

USD Billions

USD Billions

500

1,500

2,500

3,500

4,500 US Corporate

Credit Outstanding

Primary Dealer Positions

>1 Year (Left Scale)

Dealer Balance Sheets (% of Market) 

Oct. 2007: 8% Dec. 2014: 1%

Historical analysis does not guarantee future results.

Through December 31, 2014

Source: Barclays, Bloomberg, Haver Analytics, Investment Company Institute, US Federal Reserve Board and AB
2

When the global financial crisis erupted in 2008, banks that had 

invested heavily in mortgage-backed securities and other leveraged 

assets needed government support to survive. These bailouts came 

with a price—new rules designed to discourage risk-taking and make 

banks more secure.

The data suggest that these new regulations have challenged banks’ 

effectiveness when it comes to making markets. While the corporate bond market has roughly doubled in size since late 2007, banks 

have beaten a hasty retreat from the bond-trading business, cutting 

their inventories by some 75% (Display 2, previous page). As a result, 

bonds are vulnerable to wider and more violent price swings because 

the banks aren’t around to keep those fluctuations in check.

The effect has been most pronounced on corporate bonds. With 

about 5,000 global credit issuers and a dizzying array of securities 

to contend with, matching buyers and sellers can be a challenge. To 

buy a particular corporate bond, somebody has to be willing to sell it. 

That’s where banks typically came in.

Yet similar problems have developed in bigger and more liquid 

government bond markets. Turnover in the US Treasury market, for 

instance, has been in steep decline since the crisis. Over the past 

decade, the market has tripled in size to $12.5 trillion. But the average daily trading volume today has slipped to $515 billion, from $570 

billion in 2007. That means it now takes 24 days for all outstanding 

bonds to trade. In 2007, it took just eight days.1

Regulation isn’t the only culprit, of course. The Federal Reserve owns 

$2.5 trillion worth of Treasuries—most of them accumulated through 

bond-buying programs designed to suppress borrowing costs and 

boost growth.2 China holds more than $1.2 trillion more, which it uses 

to manage its exchange rate.3

But to comply with new regulations, banks, too, must hoard a larger 

share of Treasuries as collateral against their exposure to credit 

default swaps and other derivatives. As a result, the supply of 

Treasuries readily available to market makers is about $1 trillion lower 

today than it was in 2007, according to J.P. Morgan. This reduces the 

amount available for daily trading.

That’s worrisome, because less liquidity means more volatility. 

Since 2013, US, German and Japanese government bonds have 

all endured short episodes of unusually large price swings. Over a 

two-day stretch in October 2014, investors rushed into the perceived 

safety of 10-year US Treasury bonds. The yield collapsed by 31 basis 

points in just over an hour on October 15, and the price soared by 

almost 2%—a stark reminder that liquidity can be thin even in the 

most liquid markets.4 Of course, the fact that prices rose by 2% made 

it more of a curiosity than a serious concern. But would investors be 

as complacent if prices fell by 2%?

CROWDING AND THE RISE OF INDEPENDENT INVESTORS

While banks have been retreating from the bond market, investors 

have been charging into it. This is a direct result of central banks’ easy 

money policies: by driving interest rates to record lows, these policies 

pushed investors—even income-starved mom-and-pop investors—

DISPLAY 3: INDIVIDUAL INVESTORS HAVE INCREASED THEIR 

HIGH-YIELD EXPOSURE

AUM of US High-Yield Mutual Funds as a Percentage of Market Value

06 07 08 09 10 11 12 13 14

Percent

14

16

18

20

22

24

Historical analysis does not guarantee future results.

Through December 31, 2014

Source: J.P. Morgan, Lipper and AB

If everyone wants to 

exit at once, prices could fall 

very far, very fast.

1 Source: CME Group, J.P. Morgan, US Federal Reserve and AB, May 31, 2015

2 Source: US Federal Reserve, August 13, 2015

3 Source: US Treasury International Capital (TIC) System, May 31, 2015

4 Source: Bloomberg, October 15, 2014
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 3

CENTRAL BANK LIQUIDITY: 

A SHORT HISTORY

When liquidity evaporated in 2008, central banks worldwide 

stepped in to provide it by slashing interest rates and eventually 

buying huge amounts of government bonds. These were emergency policies, for use in an emergency. They were designed to flood 

the financial system with money, encourage risk-taking and get the 

economy moving again (Display, top right). Investors responded as 

policymakers hoped they would—by charging into riskier assets to 

earn a decent return.

Yet nearly a decade later, these unconventional policies are still 

in place. More importantly, they’ve become the most important 

driver of the financial market. In normal times, the decision to buy 

or sell a given asset tends to be driven by the growth or inflation 

outlook. As the economy slows, investors might trade one type 

of risk for another—say, by selling stocks and high-yield bonds, 

which tend to do poorly at such times, and buying Treasuries, 

which typically do well.

Since the crisis, though, nearly all asset classes have done well, 

irrespective of economic conditions. Growth in major economies, 

including Europe, Japan and, until recently, the US, has been paltry 

since 2008. Emerging-market growth, including that of China, has 

slowed sharply. Yet asset prices have risen. As the Display (below 

right) illustrates, since the financial crisis, excess returns have been 

more dependent on liquidity conditions than on the growth outlook.

If rallies are being driven by central bank liquidity rather than 

fundamentals, it follows that sell-offs should be, too. In fact, over 

the past two years, markets have undergone a series of selloffs—one might call them miniature fire sales—in which bonds, 

stocks, commodities and other assets have all declined. None of 

these episodes have lasted as long or done as much damage as 

the sharply correlated declines in 2008—at least, not yet. Still, the 

pattern is disturbing.

Ironically, central bank policies that were applied with the best 

intentions and designed in part to boost liquidity are helping it to 

dry up. These easy money policies aren’t over yet. But with the 

Federal Reserve likely to raise interest rates later this year, the 

beginning of the end is in sight.

POSTCRISIS, LIQUIDITY CONDITIONS DRIVE EXCESS RETURN

Relative Exposure of a Hypothetical Portfolio to Growth Outlook, 

Liquidity Conditions

0.0

0.1

0.2

0.3

0.4

0.5

Precrisis Postcrisis

Excess Returns (Basis Points)

l Relative Exposure to Liquidity l Relative Exposure to Growth

Current analysis does not guarantee future results. 

As of April 30, 2015

Precrisis: 1996–2009; postcrisis: 2009–2015

Source: AB

CENTRAL BANKS TO THE RESCUE

Total Assets of Major Central Banks (USD Trillions)

0

5

10

15

20

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

l FED l BOE l ECB l BOJ l PBC

Historical analysis does not guarantee future results. 

Through July 4, 2015

FED: US Federal Reserve; BOE: Bank of England; ECB: European Central 

Bank; BOJ: Bank of Japan; PBC: People’s Bank of China

Source: Bloomberg and Haver Analytics
4

into riskier assets, such as high-yield bonds and emerging-market 

debt, to earn a decent return. In 2014, retail-oriented mutual and 

exchange-traded funds owned nearly 23% of the US high-yield 

market, up from 15% in 2006 (Display 3, page 2). Retail ownership of 

investment-grade bonds more than doubled over the same period.

The result: large numbers of investors are crowded into the same 

trades. That causes prices to trend strongly in one direction, but may 

leave the market vulnerable to a sudden correction if everyone wants 

to sell at once.

The fact that small investors are playing a bigger role in these markets is important, because they tend to move into and out of assets 

often, depending on the latest headline or price trend. In recent years, 

investors have charged into—and out of—various assets, including 

high-yield bonds and emerging-market debt, with alarming frequency 

(Display 4).

What’s more, a great many investors—and we suspect this even goes 

for some large ones—are venturing into riskier corners of the credit 

markets because central banks’ low-interest-rate policies have 

made it hard for them to find income elsewhere. Many are taking on 

more risk than they ordinarily would. When interest rates start to rise, 

government bonds or even cash may suddenly look more attractive, 

potentially causing a rush for the door.

In theory, investors can exit an open-ended mutual fund or an ETF at 

will. But the growing popularity of these funds forces them to invest 

in an ever larger share of less liquid bonds. If everyone wants to exit 

at once, prices could fall very far, very fast. A lucky few may get out in 

time. Others will probably get trampled.

CROWDING REDUX: BIG INVESTORS REDUCE RISK

Historically, institutional investors’ large balance sheets and long time 

horizons allowed them to ride out market downturns and even engage 

in some bargain hunting, buying assets at a discount from investors 

who needed to sell.

But here, too, things changed after the financial crisis. Determined 

to avoid a repeat of the big losses the crisis inflicted, many large 

investors, including insurance companies, risk parity funds and even 

high-net-worth individuals, have adopted new risk-management 

strategies that have the potential to make liquidity conditions worse. 

This is because the investors who use these strategies may act the 

same way at the same time.

Most of the strategies use the concept of value at risk (VaR), a 

quantitative technique that measures the level of risk within an 

investment portfolio over a given time frame. If the risk level falls, 

managers may respond by buying more assets. If it rises above a 

certain level, they may sell assets to bring it back into line.

DISPLAY 5: THE GROWTH OF RISK-AWARE PRODUCTS

AUM and Leverage

AUM

(USD Trillions)

Gross Leverage 

(Ratio)

Notional

(USD Trillions)

Risk Parity $0.30–$0.50 2.0–3.5 $0.60–$1.80

Long/Short 

Equity

0.25 1.6 0.40

VA Insurance 0.30 1.00 0.30

Total $0.85–$1.05 1.5–2.4 $1.30–$2.50

Historical analysis does not guarantee future results. 

As of May 31, 2015

Source: Morningstar, Strategic Insight Simfund and AB

DISPLAY 4: CROWDING INTO AND OUT OF SECTORS

Investment Flows USD Millions

2012 2013 2014 2015

l Corporate l High-Yield l Emerging-Market l Bank Loans

Bonds Bonds Bonds

-15,000

-10,000

-5,000

0

5,000

10,000

15,000

Historical analysis does not guarantee future results.

Through May 31, 2015

Source: Strategic Insight Simfund
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 5

Doing this might make sense for a given investor, but when everyone 

is doing the same thing at the same time, it may cause market liquidity 

to dry up. This is a concern, because there’s a lot of money being 

managed this way—more, we suspect, than many investors realize 

(Display 5, previous page). A significant rise in volatility could provoke 

a large wave of automatic selling. Prices might then fall, prompting 

fear to spread, investors to sell and illiquidity to get worse.

Markets got a sneak peek at this in 2013 when the US Federal 

Reserve first hinted at plans for tapering its monthly asset purchases, 

which markets saw as a prelude to higher interest rates. A multimonth 

sell-off ensued—it later became known as the “taper tantrum”—and 

liquidity dried up. Bid-ask spreads, which measure the gap between 

the price a buyer is willing to offer and a seller is willing to accept, 

widened sharply.

That episode (and a few others since then) was also notable for 

another reason: the prices of bonds, stocks, commodities and 

other assets all declined. Normally, riskier assets such as equities, 

commodities and high-yield debt are negatively correlated with 

Treasuries and other safe assets. When risky assets fall in value, safe 

ones rise. But correlated sell-offs—one might call them miniature fire 

sales—are becoming more common (Display 6).

This is a particular problem for risk parity funds, which have proliferated over the past decade. These funds, which manage money on 

behalf of pension funds, endowments and other large institutional 

investors, target a specific level of risk and spread it equally between 

risky assets and safe ones. But they assume the correlations will be 

negative and stable. Should correlations turn positive, with stocks 

and bonds declining at the same time, the risk contribution of each 

would rise. Managers would then have to sell both to maintain their 

risk targets. In other words, selling begets more selling.

There’s another concern here: leverage. Mention leverage, and most 

people think of hedge funds. But these days, leverage applies equally 

to pension funds and other types of investors that use risk parity 

strategies. Because bonds are inherently less volatile than stocks, 

risk parity managers must buy them on leverage to equalize the risk 

contribution of the two assets. Risk parity funds tend to be leveraged 

anywhere from 200% to 350%, so bond market losses could force a 

DISPLAY 7: WHAT VOLATILITY MEANS FOR RISK PARITY FUNDS 

Potential Impact of 30% Rise for Risk Parity Based on Typical 

Asset Funds

Risk 

Allocation

Typical

Dollar 

Allocation

Notional* 

(USD Bil.)

Reduction 

in Assets

in Response 

to 30% 

Rise in Vol. 

(USD Bil.)

Equities 25% 35% $140 $32

Commodities 25 55 220 51

Rates 25 145 580 134

Credit 25 120 480 111

Total 100% 355% $1,420 $328

Current analysis does not guarantee future results.

As of May 31, 2015

*Based on estimated total AUM for a risk parity of about $400 billion

Source: AB

DISPLAY 6: CORRELATED SELL-OFFS BECOMING 

MORE COMMON

Trading Days when US Stock and Bond Returns Were Both Negative

Jun 13 Jan 14 Jun 14 Jan 15

l Stocks l Bonds

US Daily Returns (%)

–3.0

–2.5

–2.0

–1.5

–1.0

–0.5

0.0

Taper Tantrum Spring 2015 Sell-OHistorical analysis does not guarantee future results. 

Through June 11, 2015

Stocks represented by S&P 500; bonds by Barclays US 7-10 Year Treasury. 

Source: Barclays, Bloomberg, S&P and AB
6

broad sell-off in equities and other asset classes if managers rush to 

meet margin calls (Display 7, previous page).

EXCHANGE RATES GET MORE VOLATILE

Margin calls aren’t a concern for risk parity funds alone. As the 

global currency market grows more volatile, any investor who 

holds a large share of foreign assets runs the risk of being forced 

to sell if the market turns against him or her. This may be the most 

underappreciated liquidity-draining trend of them all.

By driving down interest rates, global central banks have forced 

investors to hunt for returns in foreign markets. Cross-border 

investment, of course, isn’t new. The volume of money being invested 

in foreign-currency bonds, however, has increased dramatically. 

Japanese investors poured ¥10.58 trillion into foreign fixed-income 

markets in 2014 alone, according to Japan’s Ministry of Finance, 

about US$86 billion at current exchange rates.

Most money that finds its way into global credit markets is hedged 

back to investors’ home currencies. A European investor in the US 

high-yield market who wanted to protect himself against a dollar 

decline might do this by entering a forward contract that allows him to 

sell dollars in the future at a given rate. But what if the euro declines 

instead? Then, the investor could be forced to sell his bonds or other 

DISPLAY 8: USE A BROAD, MULTI-SECTOR APPROACH

Size of Credit Sectors (USD Billions)

1,326

341

571

924

786 4,410

171

291

US

High Yield

Pan-European

 High Yield

Asia

Credit

Bank

Loans

EmergingMarket

High Yield

EmergingMarket Corps.EmergingMarket LocalTotal

Current analysis does not guarantee future results.

As of December 31, 2014

US high yield is represented by Barclays US Corporate High-Yield; pan-European high yield by Barclays Pan-European High-Yield (EUR); Asia credit by J.P. Morgan Asia 

Credit; bank loans by Credit Suisse Leveraged Loan; emerging-market high yield by J.P. Morgan EMBI Global Non-Investment-Grade; emerging-market corporates by J.P. 

Morgan CEMBI Broad Diversified; and emerging-market local by J.P. Morgan GBI-EM (since 2002) and J.P. Morgan ELMI+ (prior to 2002). An investor cannot invest directly in 

an index or average, and neither includes the sales charges or operating expenses associated with an investment in a mutual fund, which would reduce total returns.

Source: Barclays, Credit Suisse, J.P. Morgan and AB
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 7

assets in his portfolio in order to pay the insurance associated with 

his hedge. Think of it as another type of margin call.

Normally, hedging one’s currency exposure tends to improve 

risk-adjusted returns. But currency markets, like bond markets, have 

become less predictable in recent years, and large price swings have 

become more common. For instance, the Swiss franc surged nearly 

20% against the euro and US dollar in just one day in 2015 when the 

Swiss National Bank abruptly ended a three-year policy of managing 

the euro/franc exchange rate. With so much money chasing returns 

overseas, sharp currency moves like this one could suddenly turn 

large numbers of credit investors into forced buyers or sellers.

ADDING FUEL TO THE FIRE

In one way or another, the trends we’ve detailed may have driven 

investors around the world to behave the same way at the same time. 

That distorts asset prices—investors end up buying when things are 

expensive and selling when they’re cheap—and it suggests investors 

are less likely to find that their asset is liquid when they need liquidity 

most. If something were to trigger a sharp market decline, there 

would likely be plenty of sellers, but precious few buyers.

Indeed, many investors may not have a choice. They may be forced 

to sell, whether because of volatility, margin calls or sharp exchange-rate movements. And a more austere regulatory regime 

means banks won’t be around to keep asset prices in check. In other 

words, if a fire starts, each of these trends may act as an accelerant.

FIREPROOFING PORTFOLIOS

Now here’s the good news: There are things investors and their asset 

managers can do to protect themselves from liquidity risk—and 

possibly even profit from it. In the following section, we’ll examine 

each one in detail. But if there’s a common thread that holds them 

together, it’s this: Take the long view and focus on value. We think 

investors who take that to heart will find that they don’t have to fear 

liquidity risk. They just have to manage it.

Here are five things we’re doing—and that we think all asset managers should do—to fireproof clients’ portfolios.

+ Diversify using a broad multi-sector strategy. Liquidity 

can affect different sectors in different ways. So segregating 

allocations into single-sector funds—high yield, emerging markets, 

and so on—is risky; if liquidity dries up in one sector, investors can 

quickly find themselves trapped.

 A holistic and dynamic multi-sector approach that taps into a 

broad universe of fixed-income assets can offer better protection 

(Display 8, previous page). If selling spikes and liquidity dries up 

in high yield, multi-sector managers can quickly and easily move 

to investment-grade corporates or another sector where liquidity 

is more plentiful. Think of it this way—if you need water, running 

around with one bucket to catch the raindrops is hard work. A 

diversified, multi-sector strategy uses more than one bucket to 

catch more rain.

+ Be a contrarian and avoid the crowd. Staying out of crowded 

trades also puts investors in a position to make decisions based 

on value, not popularity. For example, when retail investors 

suddenly fell out of love with emerging markets a few years ago, 

investment-grade, BBB-rated emerging-market corporate bonds 

suddenly became cheaper than B-rated US corporate high-yield 

debt. That didn’t make much sense.

 More recently, investors reacted to the start of a central bank 

bond-buying program in Europe by charging into German and other 

European government bonds, pushing yields to record lows (some 

fell into negative territory, meaning investors were paying governments for the privilege of lending them money). When that inflow 

reversed, yields vaulted higher. In both cases, investors who didn’t 

follow the crowd could buy at attractive prices.

 This ability to be agile and take the other side of popular trades can 

be a crucial advantage when other investors have to sell, whether 

Avoid the crowd: 

make decisions based on 

value, not popularity.
8

it’s to meet margin calls, to reduce volatility, or for another reason. 

Think of the investors who used the taper tantrum to buy attractive 

bonds when everyone else was hitting the sell button. For providing 

liquidity when others needed it, they were compensated with higher 

yields (Display 9).

+ Keep cash handy—and don’t neglect derivatives. In illiquid 

markets, managers who keep more cash on hand than usual may 

be in a better position to swoop in and buy attractive assets when 

others are desperate to sell.

 Cash can also come in handy for meeting redemptions. No doubt 

that’s why US taxable- and municipal-bond mutual funds were 

allocating more than 9% of their portfolios to cash on average in 

2014, according to Morningstar. They were not nearly as prepared 

when the global financial crisis hit: the average cash allocation in 

December 2008 was just 1.6%.

 Of course, cash yields next to nothing today, so to offset the 

potential performance drag, managers can tap the relatively more 

liquid derivatives market to get exposure to “synthetic” securities. 

The derivatives market also gives investors access to additional 

pools of liquidity.

+ Do your credit homework—and expand your investment 

horizon. When liquidity is plentiful, it’s easy to exit trades that 

have achieved their objectives. But as we’ve seen, investors today 

shouldn’t assume that liquidity will be there when they need it. That’s 

why it pays to dig deeply into every possible investment. Multiple 

time horizons, including holding to maturity, should be considered 

when analyzing bonds. If holding a particular bond to maturity 

DISPLAY 9: WHEN YOU WANT LIQUIDITY, IT COSTS MORE

Barclays Liquidity Cost Score for US Investment-Grade Corporate and US High-Yield

Financial

Crisis

Periphery

Crisis

Taper

Tantrum

US HY

US IG Corps. 0

1

2

3

4

5

6

7

8

2007 2008 2009 2010 2011 2012 2013 2014

Percent

Historical analysis does not guarantee future results.

Through December 31, 2014

The Barclays Liquidity Cost Score measures the cost of immediately executing a round-trip transaction for a standard institutional trade.

US HY refers to the Barclays US Corporate High-Yield Index; US IG Corps. refers to the Barclays US Corporate Investment-Grade Index.

Source: Barclays and AB
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 9

doesn’t look attractive in the current environment, investors might 

want to reconsider the security altogether (Display 10).

 On the other hand, investors who have done their homework should 

trust their judgment and, whenever possible, stick with the securities 

that they consider to be sound long-term investments—even when 

market turbulence rises. One of the biggest mistakes investors can 

make when liquidity is low is to believe what the market says their 

assets are worth, not what their credit analysis tells them they’re 

worth. If their analysis is correct, those values will rebound.

 And remember: Bonds have a known ending value. As long as the 

issuer doesn’t go bankrupt, investors will earn a steady stream of 

interest and get their money back when the bond matures. This may 

be what ultimately drives returns, not day-to-day changes in price.

+ Consider selective investments in private credit. File this 

one under the “silver lining” tab: Some of the forces that have 

been reducing liquidity—namely, increased regulation—are also 

unlocking attractive opportunities. As banks originate fewer 

residential and commercial mortgages and lend less to midsize 

companies, asset managers are filling the void. Yields on many 

private credit assets—including direct loans to middle-market 

companies, privately originated commercial mortgages and 

others—are, on average, considerably higher than those on more 

traditional bonds.

 Of course, these assets aren’t as liquid as more traditional bonds. 

But as we’ve seen, liquidity can suddenly disappear anywhere in 

the fixed-income market. And remember, bonds’ primary role in 

a portfolio is to provide income. Investors with long time horizons 

might want to ask themselves how much liquidity they really need.

INTERVIEWING AN ASSET MANAGER: A LIQUIDITY CHECKLIST

We appreciate that few investors can do all of this on their own. That’s 

why it’s important to vet asset managers carefully. Before entrusting 

your money to anyone, make sure that the manager has an investment 

process that addresses liquidity risk and offers the ability to manage it. 

Here are some questions we feel investors should be asking.

+ To what do you attribute the decline in liquidity? If the asset 

managers’ only answer is “regulation,” chances are they’re not 

seeing the big picture. That could make your portfolio more 

vulnerable in a crisis. Look for a thorough understanding of the 

underlying trends.

DISPLAY 10: LENGTHEN YOUR INVESTMENT HORIZON

For illustrative purposes only

Source: AB

Investors who have done 

their homework should 

trust their judgment. 
10

 Another thing: Be wary of those who tell you that the prospect 

of higher US interest rates or the gradual withdrawal of central 

bank stimulus worldwide is the cause of the liquidity crunch. 

That’s more likely to be a spark that makes an increasingly illiquid 

environment worse.

+ How has your process changed as liquidity has dried up?

Seven or eight years ago, few people worried about bond 

market liquidity. So investors should want to know what changes 

prospective managers have made to their investment process to 

account for this new risk. Have they broadened their horizons—and 

reduced their risk—with a diversified, multi-sector approach?

 Is there cash on hand to meet redemptions and to take advantage 

of liquidity-driven sell-offs?

 How has their credit research changed? Would the advisor be 

comfortable holding the bonds in his or her portfolio to maturity, 

if necessary?

+ What about volatility? Volatility is a fact of life in markets, and 

investors should expect more of it as liquidity dries up. The best 

thing a manager can do is be prepared.

 For instance, does the manager buy “call” or “put” options—the 

right to buy or sell an asset in the future at a predetermined price 

to protect against a big liquidity-induced market move? In our view, 

doing so is a lot like spending $3 on an umbrella when the sun is 

shining. After all, we know it’s going to rain eventually.

 The alternative—waiting until volatility rises and prices fall before 

selling—is akin to buying the umbrella after the storm has started. 

Chances are you’ll pay $5 for it—and you’ll get soaked as you run 

through the rain to get it.

 For managers who use VaR-based strategies, ask if they use 

quantitative models to monitor volatility and asset correlations. 

The most effective models should allow managers to assess the 

risk of rising correlations in a way that allows them to act before 

they happen.

+ What role do traders play? Historically, traders at assetmanagement firms mostly executed orders. But as banks have 

retreated from the bond-trading business, the responsibilities of 

buy-side traders have grown. Managers who embrace a handson role for traders are more likely to be able to turn illiquidity to 

their advantage.

 A few questions to consider: Do traders play an active role in the 

entire investment process? Are they skilled enough to find sources 

of liquidity when it’s scarce and make the most of the opportunities 

caused by its ebb and flow? Do traders understand the manager’s 

strategies? Or are they simply tasked with executing trades?

CONCLUSION

During the global financial crisis, liquidity evaporated from financial 

markets in what seemed like the blink of an eye. For those of us who 

lived through it, just the thought of that ordeal is enough to make us 

sweat. That’s why it alarms us to see liquidity slowly but steadily ebbing away again from the financial markets in general—and the bond 

market in particular. While we don’t think another large-scale liquidity 

crisis is inevitable, we don’t think one can be ruled out, either. 

Yet, to paraphrase Rudyard Kipling, investors who can keep their heads 

when others about them are losing theirs are best equipped to shield 

themselves from disaster and potentially turn illiquid conditions to their 

advantage. Generations from now, the history of the financial crisis will 

focus on the damage done to markets and investors. But we shouldn’t 

forget the footnote: those who kept their cool—and whose investing 

success didn’t depend entirely on liquidity—made a lot of money. 
 PLAYING WITH FIRE THE BOND LIQUIDITY CRUNCH 11

+ Barclays 7-10 Year Treasury Index: A universe of Treasury bonds 

with remaining maturities of seven to 10 years.

+ Barclays Pan-European High-Yield (EUR) Index: Covers the 

universe of fixed-rate, sub-investment-grade debt denominated 

in euros or other European currencies (except Swiss francs). 

This index includes only euro- and sterling-denominated bonds, 

because no issues in the other European currencies now meet all 

the index requirements.

+ Barclays US Aggregate Bond Index: A broad-based benchmark 

that measures the investment-grade, US dollar–denominated, 

fixed-rate taxable bond market, including US Treasuries, government-related and corporate securities, mortgage-backed securities (MBS [agency fixed-rate and hybrid ARM pass-throughs]), 

asset-backed securities (ABS) and commercial mortgage-backed 

securities (CMBS).

+ Barclays US Corporate High-Yield Index: Represents the corporate component of the Barclays US High-Yield Index.

+ Barclays US Corporate Index: Represents the performance of 

US corporate bonds within the US investment-grade fixed-rate 

bond market.

+ Credit Suisse Leveraged Loan Index: Designed to mirror the 

investable universe of the US dollar–denominated leveraged 

loan market.

+ J.P. Morgan Corporate Emerging Market Bond Index (CEMBI): 

Tracks USD corporate emerging-market bonds.

+ J.P. Morgan Asia Credit Index (JACI) Index: Tracks fixed-rate 

USD-denominated bonds issued in the Asia ex Japan region, 

including sovereigns, quasi-sovereigns and corporate entities.

+ J.P. Morgan Emerging Local Markets Index (ELMI): Tracks total 

returns for local-currency–denominated money market instruments 

in the emerging markets.

+ J.P. Morgan Government Bond Index-Emerging Markets 

(GBI-EM): Tracks local-currency government bonds issued by 

emerging markets. The GBI-EM consists of regularly traded, 

liquid, fixed-rate, domestic-currency government bonds.

+ J.P. Morgan Emerging Markets Bond Index Global (EMBI 

Global): Tracks total returns for traded external debt instruments 

in the emerging markets, and is an expanded version of the J.P. 

Morgan EMBI+.

+ S&P 500 Index: Includes a representative sample of 500 leading 

companies in leading industries of the US economy. 

INDEX DEFINITIONS
12

RISKS TO CONSIDER

Below-Investment-Grade Risk: Investments in fixed-income 

securities with lower ratings (commonly known as “junk bonds”) tend 

to have a higher probability that an issuer will default or fail to meet its 

payment obligations.

Credit Risk: A bond’s credit rating reflects the issuer’s ability to make 

timely payments of interest or principal—the lower the rating, the higher 

the risk of default. If the issuer’s financial strength deteriorates, the 

issuer’s rating may be lowered and the bond’s value may decline. 

Currency Risk: If a non-US security’s trading currency weakens 

versus the US dollar, its value may be negatively affected when 

translated back into US-dollar terms. 

Derivatives Risk: Investing in derivative instruments such as options, 

futures, forwards or swaps can be riskier than investing in traditional 

investments, and may be more volatile, especially in a down market. 

Foreign (Non-US) Risk: Investing in non-US securities may be 

more volatile because of political, regulatory, market and economic 

uncertainties associated with such securities. These risks are 

magnified in securities of emerging or developing markets. 

Inflation Risk: Prices for goods and services tend to rise over time, 

which may erode the purchasing power of investments. 

Interest-Rate Risk: Fixed-income securities may lose value if 

interest rates rise or fall—long-term securities tend to rise and fall 

more than short-term securities. The values of mortgage-related 

and asset-backed securities are particularly sensitive to changes in 

interest rates due to prepayment risk. 

Leverage Risk: Trying to enhance investment returns by borrowing 

money or using other leverage tools may magnify both gains and 

losses, resulting in greater volatility. 

Market Risk: The market values of the portfolio’s holdings rise and 

fall from day to day, so investments may lose value.

15-1878

FIX–7289–0316

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