investment viewpoints

Fitch research reinforces likelihood of bond liquidity mismatch

Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist

“Research from Fitch has highlighted the likelihood and impact of a liquidity mismatch. Specifically, the inability of funds to sell underlying holdings as investors withdraw their cash from funds is worryingly high, with bonds being at such risk, the instant access liquidity bonds should offer is unsustainable.

Against a backdrop of today’s unprecedented negative rate environment, the direct intervention of key central banks in order to fulfil economic objectives, as well as the tightening of regulations, has structurally altered fixed income markets. This entails serious and lasting consequences for investors, including fractured liquidity – a theme we have been strongly focussed on at Lombard Odier Investment Managers.

In a world where investors cannot easily trade fixed income, the starting point, which is portfolio construction becomes a critical decision. Today, a vast majority of investors apply traditional market-cap bond indices as their starting point. This represents a significant issue for bond investors as market-cap indices reward leverage and give a higher weight to the most indebted issuers – a design flaw which we think is being amplified in the current fractured liquidity environment. Often investors turn to active managers to mitigate the flaws in market-cap, but we can expect there will be increasing pressure on higher turn-over active management as higher trading costs and lack of friction-less trading erodes performance.

In order to tackle some of the challenges facing investors today, we recommend they trade-less and build safer portfolios that exhibit quality. To achieve this investors should install explicit default risk mitigation at the heart of their portfolio construction process. This means considering fundamentals-driven portfolio construction approaches within a low turnover framework that focus on credit default mitigation.”

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This document has been prepared by Lombard Odier Funds (Europe) S.A. and is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.

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