The latest events in the Eurozone are a reminder that bond markets can face much more severe liquidity problems than equities.
The intensifying concerns over Greece’s solvency over recent days and weeks have reduced liquidity in government bonds to a minimum. Official price quotes are proving either unreliable or subject to huge bid-offer spreads.
According to a commenter earlier today on the FT Alphaville website, a 2012 maturity Greek government bond was priced at 98.5 on the Athens stock exchange, but at 78.8, nearly 20 points lower, on the Berlin exchange, suggesting that Greece’s official exchange is issuing inaccurate prices.
One London-based ETF manager I spoke to this morning confirmed that over-the-counter quotes on Greek government bonds on Tradeweb have bid-offer spreads of up to 12 points for bonds of two to three years’ maturity.
Although it is possible to trade inside the spread with a bit of effort, managing index funds and ETFs in this environment presents great challenges, the manager said. Clearly, flows into and out of indexed government bond funds under such conditions could result in heavy costs and potentially large tracking error.
Although Greek government bonds form a relatively small component of the most widely used Eurozone bond indices, as I wrote about in an article last month, the collective share in some of the most widely used indices of Portugal, Spain, Ireland, Italy, Greece and Belgium is over 50%. The Greek bond market’s severe illiquidity hasn’t spread outside the country yet, but other markets have been affected: Italy, perhaps the pivotal country in the region in view of its large debt market, has seen short maturity government bond spreads widen to a percent, my source said.
If these developments should remind us of anything, it’s perhaps of the illiquidity faced by ETFs tracking corporate bonds at the end of 2008. Intensifying sovereign debt concerns have caused a wider gap in some key corporate bond index spreads over the last week, though these remain near their lows of the last year (and highs in prices) after a massive rally.
But if contagion were to extend to corporate bond market liquidity as well, then ETFs could face problems, given the multi-billion assets of some of the leading funds.
All in all, the events of the last few weeks are a reminder that liquidity is a fickle friend – there when you don’t need it, not when you do – and that bonds are a whole different kettle of fish to equities.