BoC watching bond market liquidity

The Bank of Canada is keeping an eye on liquidity in fixed-income markets, identifying it as a vulnerability to the Canadian financial system.

The central bank, whose biannual Financial System Review report identifies risks to the system, on Tuesday referred to the “flash rally” in U.S. Treasury markets in October 2014 and the German “bund tantrum” in April 2015 as indications of increased risk for sudden drops in liquidity.

In its last FSR in June, the BoC identified excessive risk-taking as a vulnerability given strong issuance of high-yield bonds, low corporate spreads and high valuations in equity markets.

And now, “Given the new regulatory architecture, we may not know just how resilient market liquidity is until there’s a true stress event,” says BoC Governor Stephen Poloz.

Read: Risks lurk in fine print of junk bonds

The BoC’s new Canadian fixed-income forum with industry will play a role as the bank continues to study liquidity.

“Some of the watchers will be surprised that this new risk was highlighted by the Bank of Canada, because I don’t think a lot of people were expecting them to add it as third major [vulnerability],” says Cynthia Caskey, a portfolio manager for TD Wealth. “We think it’s a welcome dialogue. The more you talk about risks, the more you have contingency plans for it.”

Mutual funds and ETFs have taken up a larger portion of bond markets since the financial crisis, as investors seek yields and companies issue more bonds in a low-interest rate environment, the BoC noted.

The FSR report said the increased potential “for market liquidity to evaporate is a worry for investors and issuers, as well as a systemic concern. A sudden decline in market liquidity could exacerbate price changes and increase volatility, especially if many investors tried to unwind their positions in the same manner at the same time.”

It added that “adjustments in market liquidity are likely occurring globally, including in Canadian fixed-income funds.”

Read: Investors pull out of junk bonds, fear spike in defaults

Global financial regulations like Basel III, while strengthening the system, are affecting liquidity, leverage, and other balance sheet issues for investment dealers, says Walter Posiewko, vice-president and senior portfolio manager for RBC Global Asset Management.

“That has had more of an impact on liquidity than anything you might read in the papers today about high-yield bonds and whatnot,” Posiewko says. “It seems they [the BoC] are coming around to this reality that yes, in fact, there are liquidity issues.”

Fund managers have to be aware of more complex trading, regulations and market structures, says Raymond Kerzérho, director of research in Montreal with PWL Capital Inc. “Alternative exchanges are a big part of the market,” Kerzérho says. “It’s a much more complex environment now. Every now and then there are new risks that arise.”

Caskey says when trading ETFs, “I always recommend incorporating a limit on stop-loss orders.”

For more on the FSR, read Housing vulnerabilities have edged higher: BoC.