Liquidity is like good health. You don’t really appreciate it until you lose it.

Investors are starting to appreciate it. As volatility has surged, first in the stock market and now in credit markets, liquidity is starting to dry up across segments of the corporate bond markets. The ominous widening of spreads in the high-yield bond market — from 322 basis points on Oct. 2 to 422 points on Nov. 20 — could be a sign of trouble to come.

For bond investors liquidity is the ability to sell a bond at a reasonable price (close to where it last traded) in a reasonable amount of time. For most of the last 10 years — with a few notable exceptions — fixed-income investors have not had to worry about liquidity.

For one thing, the Federal Reserve and other central banks around the world were flooding markets with cash and pushing investors into higher-yielding assets, such as stocks and corporate bonds. There have been isolated instances of market turmoil, such as the Taper Tantrum in 2013 and the blowout in high-yield energy bonds when the price of oil tanked in 2015–16, but for the most part, fixed-income markets in the U.S. have been orderly since the financial crisis.

“We haven’t seen a lot of indicators yet of less liquidity in fixed-income markets,” said George Rusnak, co-head of global fixed-income strategy at Wells Fargo.

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“The credit markets have been relatively calm,” said Matt Toms, chief investment officer for fixed income at Voya Investment Management. “There’s been some widening of spreads in the high-yield and investment-grade markets recently, but it hasn’t caused any forced selling by investors.”

Not yet, at least. The long period of muted volatility in the bond markets, however, may be coming to an end. The central banks — the Fed, most prominently — are now tightening monetary policies, and spreads are widening across corporate bond markets. A severe liquidity crisis like 2008, when whole swaths of the credit markets shut down, may be unlikely, but there is concern that the post-financial crisis bond market could be vulnerable in a period of sustained volatility.

The big change in the bond markets since the financial crisis is the diminished role of the banks and investment dealers as investors and market makers. Prior to the crisis, banks and brokers kept large inventories of corporate bonds and issued quotes to buy and sell them with customers in the market.

For better and for worse, the regulatory reforms adopted post-crisis changed the system dramatically. Stricter capital reserve requirements by the Fed and rules against proprietary trading by regulated banks (aka, the Volcker rule) both reduced the willingness of banks and bond dealers to finance inventories and changed their role in the marketplace from principal to agent.

“The banks are in a better state now, and there’s less systemic risk in the financial system,” said Martin Fridson, a former Wall Streeter who now writes about the bond markets. “The unintended consequence, however, is a reduction of liquidity in corporate bond markets.

“It’s the price we may have to pay.”

By some measures the bond market appears more liquid than before the financial crisis. The spreads between bid and ask prices for bonds are tighter today, given the lower fees that intermediaries like the banks make for simply matching up buyers and sellers in the market. The result is lower transaction costs for investors.

“If you just look at the bid/offer spread, it looks tighter, but it’s tighter for a smaller market,” said Jason Shoup, head of global credit strategy at institutional asset manager Legal & General Investment Management America. “Liquidity doesn’t look bad most days of the year, but when volatility picks up, liquidity fades faster than it did in the past.”

Without the big banks willing to quickly execute big orders for bonds, the market is less liquid for large transactions. They typically take more time to execute and are more likely to result in price deterioration before being entirely filled. It stands to reason that prices will move more rapidly in a volatile environment where sellers outnumber buyers. “We’re now relying more on mutual funds and hedge funds to create that liquidity,” said Rusnak. “The system hasn’t really been tested yet by a period of prolonged selling.”

Adding to the problem for institutional investors are the new requirements to disclose trades to the market. The trade reporting and compliance engine (TRACE) developed by the NASD — now Finra — several years before the Financial Crisis, requires that the details of bond transactions be reported to the market. While intended to provide price transparency for all bond investors, the disclosure rules make it hard for big investors and/or bond dealers to execute large transactions without tipping their hands to the market, causing prices to deteriorate more rapidly.

The growth of electronic trading platforms for bonds provides more outlets to execute large trades, but they are still small, disjointed markets that present problems for very large transactions.

“There is more liquidity for smaller trades but less for larger trades,” said Voya’s Toms. “Investors can either piece out the order over a couple of days or engage with the Street [banks or dealers], but intermediaries are much less likely to take a position in the market now.”

Liquidity crises tend to happen quickly. Selling causes price drops, which causes more selling. While the change in bond market structure and reporting requirements won’t cause a crisis, it could exacerbate the snowball effect of panic selling.

The high-yield bond market is the most likely area for that to occur. “We could have problems in the high-yield market,” suggested Rusnak. “Companies have taken on more debt, their fundamentals are worsening, and we have larger but not deeper markets.”

The situation could also be particularly acute for BBB-rated bonds, the lowest-rated bonds on the investment grade spectrum. They now account for nearly half of the $5.8 trillion investment grade market. So-called fallen angels — investment grade credits that become junk-rated — are particularly vulnerable to liquidity crunches because many institutional investors are not allowed to invest in junk bonds. The selling that typically follows a downgrade to junk status can be massive and rapid.

“There’s a lot of worry about the BBB-rated world,” said Shoup. “It’s not an issue today, but in a recession, it’s possible that between $500 billion and $1 trillion in BBB-rated bonds could slide into the high-yield market.”

That scenario played out to a degree in the energy markets when the price of oil fell dramatically between 2014 and 2016 and led to ratings downgrades for companies. The prices of previously liquid bonds in the energy sector fell dramatically and virtually overnight as pension funds, insurance companies and investment funds abandoned the market.

If the price of oil continues to slide, it could happen again. And with the large number of potential fallen angels in the background, there is a risk of a much bigger problem if and when the economy starts to turn.

“It’s a big concern,” said Stroup. “If we have a broader recession, it could shut down the high-yield market.”

It’s in the nature of securities markets that when investors panic, buyers disappear and liquidity dries up. No regulatory or market structure solution will fix that problem.

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