Structural changes in corporate bond markets
The global financial crisis prompted a raft of regulatory changes, which fundamentally shifted the way the bond market operates. Stricter regulation and higher capital requirements saw market makers scale back operations, pushing liquidity lower and transactions costs higher.
Here we look at the impact of this structural shift.
1. Structural changes have changed the risk/reward trade-off
Transaction costs play a crucial role in effectively generating alpha from active management. Regulation introduced since the financial crisis has increased the amount of capital that banks are required to hold against their trading books, forcing them to de-leverage. This has had the impact of dramatically reducing the volume of bonds banks are prepared to hold in their market-making activities. The knock-on effect has been reduced liquidity, resulting in increased dealing costs.
With the potential upside on successful bond purchases being so small (an inherent characteristic of the fixed income asset class), the higher cost structure is making it increasingly difficult for active managers to make decent returns (net of fees) without significantly increasing risk levels. Illiquid markets have thus made active management more difficult, both in terms of implementation and in terms of delivering a positive return.
2. Structural changes have driven the cost of passive investing higher
It might seem that passive investment strategies provide a more efficient solution in this scenario. However passive funds, by design, are subject to unnecessary trading – and in an environment where trading is more costly, this means more performance leakage as well. An indexed passive fund is tied to a benchmark (which typically rebalances at the end of each month) and is managed according to a rules-based approach. As bonds fall in and out of the benchmark, the passive fund is require to follow suit and trade the same names. It is estimated that following this rules-based approach costs a typical passive fund 25 basis points per annum in unnecessary transaction costs1.
3. Can a Buy and Maintain strategy be a good fit in this new environment?
In spite of the strategy name, AXA IM’s Buy and Maintain portfolio construction and risk monitoring processes are very much ‘active’ and pragmatic – and not at all rules-based. It was designed explicitly to address investors’ growing frustrations with both the high cost of active credit management and the inefficiencies of passive index-tracking in the post-crisis world. The strategy sits in the middle of these two approaches and combines the best of both: the skill and added-value of AXA IM’s active credit process, and the low-cost edge of passive management.
Buy and Maintain strategies are able to effectively address the problem of structurally lower liquidity by minimising unnecessary turnover. They do this in the following ways:
- Buying attractive, high quality bonds with the intention of holding them to maturity.
- Maintaining a carefully ‘laddered’ cashflow profile, which delivers a steady stream of ‘organic’ cashflow to reinvest and refresh the portfolio with. This allows us to benefit from new opportunities and maintain the desired portfolio characteristics over the long term without incurring unwanted transaction costs.
- Avoiding the forced selling inherent in passive strategies. This includes not automatically selling a bond on a downgrade, provided the credit quality is sound, nor when a bond is approaching maturity.
Maximising the use of low cost entries to the market, such as the new issue (‘primary’) market. This is also an area of the market that many passive funds are unable to participate in and consequently miss out on attractive concessions compared with trading in the secondary market.
Please note: investments involve risk , including the loss of capital.
Watch Lionel Pernias, Head of Buy and Maintain London at AXA Investment Managers discuss these topics below.