There are likely to be more issues with financial market liquidity because of central bank intervention and tougher regulation. Investors in fixed income must reset their portfolios accordingly, this article argues.

Whatever one thinks of it, today is the era of central bank experimentation, as the likes of the Bank of Japan, European Central Bank and US Federal Reserve ply the world with bouts of quantitative easing, yield curve “twists”, “tapers”, negative real rates and forward guidance. (It is hard to keep pace with the jargon.) Whether all this action will lead to a more stable monetary world in the future or – as some gloomier commentators suggest - monetary collapse and a return to metals, is a moot point. In this article, Salman Ahmed, who is chief global strategist at Lombard Odier Investment Managers, takes a look at the monetary landscape and how it influences investment thinking. As ever, readers are invited to respond.

The world has changed. The old map will no longer help navigate fixed income markets. The roads have changed, towns have changed and even the land itself has changed – with a quarter of the territory fenced off and no longer accessible.

What caused this? Put simply – the central banks have become dominant players in bonds in order to fulfil their economic incentives. For everyone else, that is a problem. It means taking greater risk for uncertain returns and a new approach to fixed income is needed.

The influence of central banks is extraordinary. They now hold on average 25 per cent of sovereign bonds in advanced economies, with the European Central Bank (ECB) extending its buying to corporate bonds. Indeed, by the end of 2017 it is estimated that the ECB will hold 34 per cent of total German public sector debt. They held almost nothing before 2008. The policy of using the printing press and relying on non-traditional channels of monetary policy transmission has also created some serious unintended consequences.

Over the last two years, fixed income markets have gone through a number of micro liquidity “accidents”, where the act of moving bonds into cash has had an outsized impact on pricing. The most extreme example of these accidents occurred in mid-2015 when bund markets seized up as yields shot up from five basis points to more than 1 per cent in a matter of days. The pressure we saw on European financials in early February could also be partly explained by these movements. In our view there are two reasons for these accidents – increased herding and tighter regulations.

IMF analysis shows that herding or commonality in investor positions has risen sharply since early 2011, especially in fixed income. The extensive use of QE can explain this dynamic. Investors were incentivised by central bank policies to increase fixed income allocations, which were then predominantly implemented through market-cap weighted portfolios. This means that when there is a shock to expectations, investors start to move together in herds, thus creating a rush for the exits.

However, that is only part of the story – tightening regulations (e.g. Basel III, Dodd Frank and the Volcker rule) have directly impaired the banking sector’s ability to intermediate, especially in corporate bond markets. This has resulted in a sharp fall in bond inventories held by market makers. Indeed, based on recent IMF survey reports, regulation is quoted as one of the primary reasons by market makers in both the US and Europe behind their reduced ability to make markets in fixed income.

This results in frequent micro liquidity accidents as the rewired financial system struggles to cope with shifts in investor expectations. This creates episodes of sharp volatility accompanied by widening transaction costs, which in many instances then requires central bank attention.

All in all, we believe there are likely to be more issues with liquidity due to central bank intervention and tighter regulation. We also foresee there will be continuing disinflation and low rates across most markets, so the need for yield from fixed income should remain. The investment mindset clearly has to change. Investors must go back to basics and think about redesigning their portfolios to take into account the changing world of fixed income.

In our view, when liquidity storms hit, a portfolio designed to focus on the underlying fundamentals of an investment will help mitigate underlying credit risk and give an investor confidence to look for yield in markets traditionally seen as riskier. When liquidity storms hit, a portfolio designed like this should be better able to withstand the shocks, thanks to reduced risk of default. This is the new world order for fixed income investing.