Blog : Investment | November 22, 2022

Managing liquidity risk in the world’s deepest bond market

Roger Hallam
Global Head of Rates
John Madziyire
Senior Portfolio Manager
(Editor’s note: Roger Hallam and John Madziyire help manage Vanguard’s lineup of active fixed income funds, nearly all of which have some investment in U.S. Treasuries.)
U.S. Treasuries enjoy the deepest and most liquid bond market in the world. Yet this year the Treasury market has seen its liquidity deteriorate significantly, though it is still functioning and orderly. The current lack of liquidity rivals the worst of the 2020 crisis caused by the arrival of COVID-19 and leaves all financial asset classes exposed to potential volatility.  

How can this be? What does it mean for investors and Vanguard bond fund investors in particular?

Central bankers, regulators, and investors are focused on this issue because Treasuries—considered “risk-free” from a credit perspective—are the cornerstone of modern finance, helping to set the price of every other U.S. dollar-based financial asset and instrument, including investment-grade bonds, stocks, and mortgages.  

When the price of Treasuries is difficult to determine because buying and selling has slowed, volatility in both the stock and bond markets is prone to follow. One recent example from overseas: The United Kingdom experienced turmoil in its markets after gilt yields spiked beginning in late September.

The situation that caused U.K. gilt yields to jump is much different than the situation in the U.S. Still, the event accentuated legitimate concerns about what might happen if U.S. markets were also to suffer a shock and if there were a rush to sell Treasuries to raise cash but few buyers available. 

The U.S. Treasury market has grown dramatically  . . . 
Source: Federal Reserve, as of April 1, 2022 (latest data available).
. . . But liquidity has been evaporating 
Notes: Treasury market depth refers to the ability of a trader to buy or sell Treasuries without substantially moving prices. J.P. Morgan's measure includes the average size of the best three bids and offers for trades between 8:30 and 10:30 a.m., Eastern time, each trading day.
Source: J.P. Morgan, as of October 31, 2022.

Why are there liquidity problems? 

Treasury market depth—as measured by the amount of Treasuries that can be traded without significantly impacting the price—has been declining since the Fed started tapering bond purchases at the end of 2021.

There are several reasons why liquidity has decreased. Among them: 

  • The size of the Treasury market has doubled to about $25 trillion in the 10 years ended December 31, 2021, and it is more than six times the size it was 20 years ago.  
  • At the same time, primary dealers’ capacity to intermediate trades has been constrained since the 2008 global financial crisis due to tighter regulation, which limits their ability to warehouse risk in Treasuries. 
  • The Federal Reserve decided to stop buying Treasuries in order to wind down the Fed’s balance sheet, leaving the market without a major buyer. 
  • Bond yields have seen high volatility due to increased uncertainty about the economic outlook and future potential interest rate hikes by the Federal Reserve.

Has this happened before? 

The Treasury market has experienced severe bouts of illiquidity in recent years. In 2019, the repo market—where banks lend to other institutions overnight in exchange for Treasuries as collateral—seized up. The Fed cleared the clog in the repo market, considered the essential plumbing for the U.S. financial system, by lending out billions of dollars into the system.

In March 2020, as the effects of COVID-19 bore down on the economy, global market participants sought to bolster their liquidity positions in a “dash for cash.” As a result, U.S. Treasury markets, long hailed as a traditional safe haven during times of market stress, experienced notable pressures. Markets began to normalize only after central banks and policymakers intervened to provide fiscal and monetary support.

The Federal Reserve, Securities and Exchange Commission, U.S. Treasury, and U.S. Commodity Futures Trading Commission formed a working group in the aftermath of the March 2020 meltdown to look at the Treasury market structure. On November 10, this working group released an update that summarized the work so far. 

Treasury market volatility rising
Note: The ICE BofA MOVE Index tracks implied volatility in the U.S. dollar-based Treasury options and swaps markets.
Source: ICE BofA MOVE Index, as of October 31, 2022.

What if?

If a shock roils the Treasury market again, the Fed can use its playbook from March 2020 to deal with any emerging situation.

Of course, given today’s higher inflation, the Fed would not be enthused about adding dramatically to its balance sheet. But the market is aware that the Fed can intervene, and such measures could go a long way toward calming markets, if necessary. This response would only be a short-term solution, however, and not address the underlying structural concerns.

For example, when illiquidity and volatility spiked to extreme levels earlier this year in the U.K., the Bank of England only needed to purchase $21 billion worth of gilts in September and October to help settle the market. The withdrawal of a proposed tax cut package and the selection of a new prime minister also led to greater calm.

Investors should also remember that even if the Treasury market suffers from structural challenges that contribute to greater volatility, Treasury bills, notes, and bonds—backed by the full faith and credit of the U.S. government—remain the most secure investment instruments in the world.

What we’re doing

While we have suggested that policymakers consider a number of enhancements to the Treasury market structure,1 reforms may take time to implement. During times like these, it is important that Vanguard maintains a robust focus on risk management and strong relationships with market makers and others in the financial ecosystem.  

Nonetheless, we have a high level of liquidity in our active fixed income funds. We’ve achieved that through being relatively overweight the most-liquid Treasury issues across the curve and having a slightly higher cash balance than usual in our actively managed Treasury funds. That cash and liquidity enable us to easily meet any redemptions, if that becomes necessary, or to take advantage of any market dislocations that may occur so that we improve long-term outcomes for our investors, who are also our owners.2

While our active funds constantly strive for outperformance over benchmarks and competitors, we also keep top of mind the idea that bonds serve as a stabilizer for client portfolios—which means we would rather err on the side of caution when we see potential trouble ahead. 

1 Choa, Samantha, Brad Collins, Jeffrey A. Johnson, Brian P. Murphy, and Joshua Zalasky, 2021. The Dash for Cash: Observations on the Fixed Income Market Ecosystem During COVID-19. Valley Forge, Pa.: The Vanguard Group.

2 Vanguard is investor-owned, meaning the fund shareholders own the funds, which in turn own Vanguard.


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