A new DNB study argues that the increased likelihood of market shocks is a new fact of life, which investors have to take into account. More effective risk management, liquidity stress tests and other preventative measures can limit the risks.
Market illiquidity and concentration
In recent years policy makers and investors have increasingly drawn attention to the diminished marketability of bonds, or market illiquidity. An illiquid market is characterised by higher transaction costs (bid-ask-spreads), lower transaction volumes and a greater price impact of transactions. Since the global financial crisis there have been indications that liquidity has deteriorated in some financial markets (see the autumn 2015 DNB Overview of Financial Stability). This is possibly a result of stricter regulations for banks, the current unconventional monetary policies and changing market structure. In addition, certain bonds are concentrated in the hands of a limited number of entities, such as major investment funds. When these entities attempt to sell their portfolios, it can have major repercussions for the market. These two factors combined may create new systemic risks.
To study these systemic risks further, DNB has analysed market shocks in the European bond market over the last three years. In May 2013 interest rates spiked in response to uncertainty about the pace of the US Federal Reserve's bond-purchasing programme. This global market shock came to be known as the "Taper Tantrum." Spring 2015 also saw a sharp rise in yields on German government bonds (Bunds) – the “Bund Tantrum.” The new DNB study (see download) analyses the price volatility of individual government, corporate and bank bonds over both these periods.
The results confirm that illiquid and concentrated holdings of securities underwent larger shocks during the Bund Tantrum. During the Taper Tantrum, this only applied to illiquid bonds; concentrated holdings of bonds did not have a statistically significant and robust effect on the intensity of the market shocks. An analysis of the sales and purchasing behaviour of European investors also shows that primarily households, money market funds and other financial intermediaries sold bonds during the Taper Tantrum and Bund Tantrum (see figure). This procyclical investment behaviour could have amplified the price shocks.
Figure: Net transactions during the Bund Tantrum
Changes in the nominal portfolio value of government, bank and corporate bonds in EUR billion, by holder sector, in Q2 2015.