Shrinking liquidity in global financial markets has left the corporate bond market facing a ticking timebomb, leading fund managers say. Asset managers speaking at the Reuters Global Investment Outlook Summit and representing more than $2 trillion in assets said tougher regulation and a slide in bank trading had teed up trouble if a rise in record low default rates forced investors to try and sell out at the same time.
This may not be an issue for 2014 as all pointed to continued strong demand from insurers and pension funds chasing higher yields than those offered on safer sovereign debt, but with most holding the debt rather than trading it on, secondary market demand remains untested.
Bumper deals this year have included US telecom company Verizon's $49 billion issue to fund a buyout of UK joint venture partner Vodafone, which helped push global investment grade issuance to $2.3 trillion in the year to October.
Concern about defaults, however, is most keenly felt at the more speculative end of the market, called high-yield, where issuance is at $414 billion so far.
"At the moment they are buying at low-yield levels they are being handsomely compensated for default risk because there will be hardly any defaults in the next two years," said Hans Stoter, chief investment officer at ING Investment Management, which manages $238 billion.
"But if we move to the next default cycle, which is, I think, two to three years away, and people really get worried about getting their money back and they want to exit their positions, then we are going to be in a full room heading for the exit door and the door will turn out to be a very small one."
While the default rate trigger is unlikely to come in the immediate future - a survey of fund managers handling 7 trillion euros of fixed-income assets by ratings agency Fitch showed a sharp drop in those who saw a high risk of prolonged recession in Europe - the liquidity timebomb will remain.
The current rate is a below-average 2.5 percent but US financial research firm FridsonVision recently forecast it would spike to 8.4 percent between 2016 and 2020.
When the default rate rises, debt holders will likely see the price of their bonds fall as the market demands a higher yield to take on the risk. If the holders try to sell and buyers are scarce, they could have to accept a worse deal.
For Giordano Lombardo, chief investment officer at Pioneer Investments, a unit of Italian lender UniCredit with more than 230 billion euros in assets under management, this was driven by the scaling back of bank trading operations.
With investment banks, many of them big buyers of bonds when they traded for their own account - so-called proprietary trading - increasingly not in the market, the buyer of last resort in the event of a bond pullback is not there.
That structural shift was also being exacerbated by regulation such as Solvency II, which defined risk in terms of volatility and therefore prevented insurers from buying more equities, Lombardo said.