by Paul Kilby

Liquidity in Latin America’s corporate debt markets has always been thin, but there is a growing unease that the situation may worsen as banks cut back trading activity in the region ahead of the implementation of the Volker rule and other regulatory requirements.

As European banks beat a retreat, Brazilian institutions are to some extent filling the void as liquidity providers. But in a new issuance market now dominated by corporates, illiquidity is at the forefront of investors’ minds, forcing them to be more guarded than ever in how they construct portfolios.

“Given my discussions with bondholders, they all say liquidity over the past year has deteriorated,” says David Spegel, global head of EM strategy at ING. “And that is a big concern for them.”

The inability to trade in the secondary market has been a hot topic since the 2008 crisis when investors struggled to exit positions because dealers simply refused to bid. Investors are now asking what sort of premium is required to compensate them for that risk and how best to approach a market that is increasingly populated by illiquid corporate bonds.

Banks have been keeping a close eye on discussions over the Volker Rule, which prohibits proprietary trading at banks, with some heavy lobbying seen against the measure during the comment period that ended in mid February.

“There is a lot of concern from issuers, investors and banks about how liquidity for corporate bonds will change in the new regulatory environment,” says Karan Madan, Barclays’ regional head for Latin America. “It is an evolving discussion and I am hopeful we will end up with a compromise that preserves the depth of liquidity the market needs to function properly.”

For many, the distinction between market making and proprietary trading remains a grey area under the Volker Rule, leaving lead banks exposed to regulatory risks that many would rather not take.

Uncertainty over the exact wording of the final legislation has left many investors in a wait-and-see mode and less willing to take on risk.

“This will make portfolio construction difficult,” says Polina Kurdyavko, senior portfolio manager at BlueBay Asset Management. “We still haven’t heard the final version, but whatever the final version is likely to be, it is going to make it more difficult for banks to hold big inventories, especially when it comes to Eurobonds.”

Across EM, traders are being told to cut their limits and inventory is already shrinking, while at the same time new issuance volumes reached record levels at the beginning of this year. This dynamic has only magnified market illiquidity, and leaves investors falling back on primary markets to pick up sizable tickets.

“Clients are concerned because we are almost becoming a primary-only market,” adds Spegel. ”You buy and expect to hold.”

This is important in a market that still faces many uncertainties, such as the outcome of the European debt crisis. If asset managers are suddenly faced with a wave of redemptions should the situation in Europe deteriorate, liquidity is key to meeting those payments.

“You have to run a more conservative portfolio until you get more clarity on the final picture,” says Kurdyavko. “Across the board managers will raise their cash levels as they want to have a bit of cushion in case of an uncertain scenario.”

For some investors this means taking a longer-term and more cautious view to buying bonds. “If something goes wrong and you haven’t done your homework, you are not going to get out,” says Robert Abad, a senior analyst at Western Asset Management, which has $39 billion under management in EM.

The buyside has not only been asking for a liquidity premium, but in some cases establishing size thresholds before they participate. This is bad news for borrowers across the board, but especially for junk names that may need to raise only small amounts at a time or simply can’t afford to pay higher borrowing costs.

“We have done a lot of EM high-yield and a good 50% of investors say they love the story, but it is too small,” says Clayton Pope, head of Credit Suisse’s EM bond syndicate desk in New York. “Others are more than willing to take that risk.”

The abundance of retaps earlier this year partly reflects such dynamics as reopenings satisfy the buyside’s need for greater liquidity and are cheaper for the borrower than creating a new benchmark.

Arguably, demand in the primary for lack of liquidity in the secondaries has benefited borrowers as investors seek to buy more new issues instead. “New issues are available…that is [partly] why they are so well received,” a trader says.

Overblown Concerns

For some, talk of shrinking liquidity has been overblown, especially in Latin America, where the secondary market for corporate bonds has never been particularly active.

Indeed, syndicate managers have long complained about price discovery in the primaries for certain credits whose secondary levels rarely reflect where the bonds trade, at least in size.

Efforts by the buyside to limit primary purchases to deals with sizes of $250 million or higher are also seen as farcical, as size doesn’t necessarily say much about a bond’s future liquidity.

The real question to ask is how diverse the investor base is on a particular trade. The more varied the buyer base, the more likely accounts will find a market when they want to sell.

Record new issue volumes in the primary market during the first five weeks of the year have also arguably helped sustain trading activity as investors flip out of deals or buy paper after failing to receive decent allocations.

In EM, bankers also see the situation as less dire than in Europe, where banks are retrenching. In LatAm and other emerging markets, however, local banks are coming in to fill the void and are more than willing to be liquidity providers.

The real test will come when the market suffers another period of duress, which it inevitably will. LF