Liquidity is defined as the degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.
The strong end to the week has perhaps papered over the major cracks that are starting to become more obvious in the bond markets. On Thursday the German 10-Year government bond yield jumped 21bps to hit an intra-day high of 0.80%, before closing the day back where it started, at 0.59%.
This raises serious concerns about the liquidity in bond markets, as banks have been forced to step back from market-making activity. Remember this is “least risk” AAA government bonds we’re talking about. Three weeks ago it was trading at a yield of 0.05.
Move out the risk spectrum and you have to wonder about the impact on prices during the next taper tantrum, as investors rush for the exits at the same time. The warning is simple, be careful reaching for extra yield, moving into long dated bonds or into lower quality bonds. Don’t take extra risk with your eyes closed.
Government bonds are supposed to be the boring part of an investment portfolio, providing investors with a regular and reliable income, and adding some diversification against the large declines that have become more common in other asset classes such as equities and property. To a certain extent this dynamic has changed, as bond prices have been bid higher in the search for yield.
Bonds are no longer boring, so it is crucial to understand the type and maturity of the bonds you own in your portfolio, how they might perform in a rising yield environment. My recent blog – The Mechanics of Fixed Rate Government Bonds – provides a useful refresher on how fixed rate bonds work.