The Global Liquidity Crisis: European Fixed Income, Before And After
( Greenwich Associates )
(January 22, 2008)
Tuesday, January 22, 2008 Greenwich, CT USA - New research from Greenwich Associates reveals that European fixed-income markets were undergoing a transformation in the run-up to the global credit crunch. While many of the changes experienced in the 12 months prior to the summer of 2007 came to an abrupt halt with the outbreak of the ongoing global liquidity crisis, it remains an open question as to which products, practices and trends will recover and reemerge as permanent market features, and which are gone for good:
- Volume Growth
Customer trading volumes in the European fixed-income market had been growing at a steady 8% clip for the two years leading up to the summer 2007 start of the liquidity crisis. In the United Kingdom, fixed-income trading volume surged by nearly 32% and more than 40% excluding interest-rate and structured credit derivatives from 2006-2007. In July and August, trading in many fixed-income products ground to a complete and sudden halt.
- Product Diversification
Institutional investors in 2006 and the first half of 2007 were diversifying their fixed income businesses by increasing their activity in less liquid and potentially higher yielding instruments. In 2006, government bonds made up 56% of European cash bond trading volumes; by the summer of 2007, that share had fallen to just 51%. In September 2007, however, more than 45% of European institutions participating in a special Greenwich Associates study said they had deliberately adjusted their portfolio's credit profile as a result of market conditions, including more than half the largest institutions in the study. The moves were almost universally in the same direction: away from risk in general and from mortgage and real estate exposure in particular, and into higher-rated instruments, especially shorter-duration government securities.
- Structured Product Proliferation
Trading volumes in structured credit products more than doubled and CDO trading volume increased more than 70% in the year before the crisis. When surveyed in September, 50% of participating European institutions said the performance of CDOs and other structured products during the liquidity event had made them less likely to invest in these products going forward.
- Hedge Fund Expansion
Fixed income trading volumes among European hedge funds increased almost 48% overall in the 12 months prior to the start of the credit crisis, and hedge funds represented nearly 8% of European fixed-income trading volumes as of August 2007.
Much of the growth in hedge fund trading volumes was the result of a sharp pick-up in hedge fund activity in investment-grade credit products, in which total trading volumes increased more than 20% from 2006 to 2007. However, a surge in hedge fund investments in structured products and other fixed-income instruments meant that hedge funds made up a significant proportion of the overall European fixed-income market when the credit crunch began to unfold. In the year leading up to the crisis, hedge funds accounted for:
- 16% of trading volume in structured fixed-income products;
- 42% of trading volume in liquid high yield credit derivatives;
- 35% of high yield cash bond trading volume;
- 11% of trading volume in liquid investment-grade credit derivatives;
- Almost a quarter of trading volume in leveraged loans.
"Although hedge funds represented less than 3% of European trading volume in asset backed securities, their activity and investment in this sector had increased significantly in the months before the market turmoil," says Greenwich Associates consultant Woody Canaday. "In fact, hedge funds had ramped up their activity in many of the products that came under the most pressure in dislocations in July through September."
"On a very broad basis our research shows that the tremendous liquidity that existed in the system prior to the July-August period was changing the behavior of Europe's institutional investors in a variety of ways," says Greenwich Associates consultant Peter D'Amario. "Quite suddenly, however, investors' attention was brought back to the basics of the fixed-income market: Do I have access to liquidity? Are my dealers standing by me? The crisis served as a painful reminder that, no matter how innovative the product or sophisticated the strategy, the foundation of every institution's fixed income business is the liquidity an institution derives from its trading relationships."
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