Dan Fuss likes to describe the structure of the corporate bond market as resembling an ice cream sandwich: bonds change hands between the two crispy wafers on either side, but there’s a fluffy layer in between that facilitates each transaction.
“It’s a good sandwich if there’s a whole bunch of ice cream on the inside,” says Fuss, a bond market veteran who runs the $21.9 billion Loomis Sayles Bond Fund. But in recent years, that creamy inner layer, commonly known by the less appetizing title of “dealer,” has been melting.
Dealers were once powerful arms of Wall Street’s biggest investment banks, such as Merrill Lynch, J.P. Morgan and Lehman Bros. They used their large trading desks to make markets for investors to buy and sell securities. But the shifting roles of these large banks since the financial crisis, often pinned on financial regulations like the Volcker Rule, has caused a steep drop in the volume of debt securities these investment banks hold.
The cushion protecting fixed-income investors from market shocks, particularly in the $6.6 trillion corporate bond market, is melting, which is creating a new form of risk when it comes to buying these securities. In response, investors are reevaluating how they hold bonds sold by companies from Apple Inc. to Ford Motor Co. to DreamWorks Animation, as well as reshaping how they interact in the secondary trading market. The changes have served as a key factor eroding the traditional conviction that the bond market shields investors from risk.
Liquidity droughtCreated by Terrence Horan
The financial crisis forced the surviving Wall Street banks to reduce risk in a hurry. Many have downgraded their roles as market-makers for corporate bonds, taking fewer bonds onto their books for future sale. Market participants blame the constricting regulatory forces of capital requirements and the post-crisis Volcker Rule. Regulators have pinned the blame back on the banks, which raced to shed less-liquid assets even before regulations were enacted.
At the same time, a surge in new bond sales has increased the size of the market even as dealers, the key facilitator to helping those bonds change hands in the secondary market, have become less willing to handle them. The result is a bond market which is flush with new securities but hobbled when it comes to pricing and trading these securities after the initial sale. As liquidity evaporated in the wake of the financial crisis, it has adjusted the way large asset managers hold and trade bonds, which then impacts the retail investors who put money into mutual and exchange-traded funds (read one institutional investor's story). Here's what's at stake:
- Buyers are paying a premium to own liquid bonds
- Investors who need to sell bonds in a hurry are finding less stable prices
- A chaotic exit from the bond market could cause yields to spike and portfolio values to drop
These market shifts are set against the backdrop of a widespread fear that investors will leave the bond markets en masse as interest rates rise. Concerns about low bond-market liquidity mounted this summer as investors ditched bonds in what bond guru Jeffrey Gundlach has called a liquidation cycle (see what investors were saying at the time). The 10-year Treasury note yield spiked by more than 1.3 percentage points over the summer, briefly touching 3%, on concerns about a Federal Reserve wind down of its bond-buying stimulus program, which was announced last week. The benchmark note traded near 3% on Dec. 27.
The summer bond selloff propelled the corporate bond market to a brief correction characterized by wild movements in prices, though investment-grade prices rapidly recovered. If an event in the credit or rates market provokes another panicked rush to the exits, without the help of dealers as a cushion, it could strain the market and further exacerbate price swings. The fear is that what might have been a moderate selloff could cascade into a rout, sending costs on mortgages and corporate debt sky high.
“I think people have gotten too comfortable, nay complacent, with how this exit process works,” says Tom Murphy, sector leader for investment grade credit at Columbia Management. Investors have piled money into corporate bonds in the years since the financial crisis, but that could translate to chaos if sentiment reverses all at once.
But there’s always a silver lining, and the liquidity struggles facing the market may finally be heralding a broader discussion about whether and how the bond market can better meet the needs of investors. Buyers of debt would ideally like to be able to trade large blocks of bonds quickly and cheaply. The holy grail for many investors is something akin to the way equities trade: in high volumes with tight differentials between the price of a buyer and seller.
That’s a difficult proposition, if not impossible. The corporate bond market is by nature fragmentary: while a company has one ticker symbol on a stock exchange, that same firm can have dozens of outstanding bonds, each with their own peculiarities. The wide range of differentiation allows companies easier capital markets access and it provides opportunities for investors who can parse the relative value of different issuances. It’s also at the heart of what makes it so hard to ensure a liquid market.
“The market is a mile wide and an inch deep,” says Will Rhode, director of fixed income at research firm TABB Group.
With liquidity making trading more difficult in the corporate bond market, there’s a growing recognition that a solution is needed, and that it may have to go beyond simply adjusting the point of interaction between dealers and investors. The whole market may need to evolve -- from standardizing the way bonds are issued to funneling the market toward a new trading structure.
The issue has long been top-of-mind among market insiders, but isn’t as widely discussed among the vast pool of investors who buy into the bond market for its perceived security. MarketWatch interviewed a range of corporate bond market participants in recent months to assess the origins of this shift, the reconsideration of trading strategies that it’s spurred among bond investors, and a possible path towards a better functioning bond market.
Before the financial crisis, dealer market-making held a powerful place in the nation’s biggest investment banks. The fresh-out-of-college traders that shuffled in and out of Manhattan bank buildings each day handled the banks' inventories of bonds worth hundreds of millions of dollars, which they used as starting capital to make their own trades, says Lawrence McDonald, a former Lehman Bros. corporate bond trader. The holdings, which were used to make markets for each type of corporate security, would fit into two categories, or books.
“The front book is the facilitation book. That’s the book for client liquidity. The back book is your prop position. That book was responsible for a lot of profits on the Street in 2007, and that today pretty much doesn’t exist,” said McDonald, who authored A Colossal Failure of Common Sense, a bestseller about the bank's demise.
That system crumbled in the years after the financial crisis. The facilitation books shrank in size while the proprietary trading books became virtually non-existent. Dealer balance sheet sizes fell to a fraction of what they once were.
The smaller amount that dealers hold on their books means they can’t unconditionally buy bonds that investors are trying to sell, especially in large blocks. But there’s another issue at play: the low interest-rate environment that characterized much of the post-crisis economy has brought many new issuers into the market. New corporate bond sales have surged as issuers rushed to take advantage of still attractive rates and investors sought the relatively higher income of corporate debt.
The combination of smaller holdings by dealers and a surge in the amount of outstanding corporate debt suggests that there’s more inventory to change hands with fewer institutions willing to facilitate those transactions. Whereas dealers once held about 4% of all outstanding corporate debt on their balance sheets, they now hold closer to 0.5%, according to Oliver Randall, a professor of finance at Emory University, who has done research on corporate bond market liquidity (see more about his research).
Even as most sides recognize there’s a lack of liquidity in the market, there’s a fundamental disagreement about what caused it. Market participants are quick to point to new regulations that limit proprietary trading by dealers and increase the amount of reserves required to be held by banks. In that sense, the liquidity drought has provided ammunition for critics who believe financial reform has been destructive to the markets. But government officials are equally quick to suggest that banks have become less tolerant of risk.
The Volcker Rule was passed as part of the Dodd-Frank financial reform bill in 2010. It banned banks from trading securities with their own money, or proprietary trading. The rule has become one of the more controversial pieces of the regulatory regime, even though the final regulations were only laid out in early December. Nonetheless, banks had already wound down their proprietary trading operations in anticipation of the rule taking effect, and market participants say the lack of clarity about how much of dealers' standard trading activity would be considered proprietary further cut into their market-making ability ahead of the release of the final regulations (read NYSE CEO Niederhauer's take on the Volcker Rule and bond markets) .
The other focal point of regulatory reform is the Basel III capital regulations, which force banks to hold higher levels of reserves as a buffer against the type of bank leverage that expedited Lehman's fall into bankruptcy and kicked off the financial crisis. It’s making the dealer arms of banks less able to deploy capital to make markets in corporate bonds, market-makers told Treasury officials .
Lawmakers have cited broader shifts in trading practices as possible reasons for the decline in market-making ability.
New York Federal Reserve economists did research on the summer 2013 bond selloff, looking at how market-making ability changed as investors left the bond market as a whole. They concluded that even though dealers stepped back from their roles as intermediaries during the selloff, the dealers for whom there was more regulatory breathing room to take on risk actually took less risk. That indicated market-making ability was driven less by capacity limitations from regulations, and more by self-imposed limits on risk.
Finger pointing aside -- and excluding other reasons, such as hesitancy of trading outside the benchmarks set by pricing-disclosure platform Trace -- there tends to be a widespread recognition that the historic ability to take on risk has evaporated, forcing a shift in the way investors trade bonds. The bottom line, says Fuss of Loomis Sayles, is that it’s, “rules, both written and internal, as to the risk [dealers] can take carrying inventory.”
The total amount of trades in the high-grade corporate bond market has actually increased in the last five years, which seemingly contradicts the idea that liquidity is drying up. But alongside that rise, trade sizes have shrunk markedly, indicating that investors trying to route their trades through Wall Street have had to break up their trades to accommodate smaller balance sheets.
This change has given small firms an unusual advantage on Wall Street, where mammoth investors often have an edge because of their size.
Chris Keith manages portfolios for individuals at Newton, Mass.-based Adviser Investments, which has roughly $2 billion in assets under management. When he’s in the market, he’s trading in smaller quantities than the major asset managers, which means he doesn’t risk overwhelming the Street with his inventory.
“I haven’t seen any problems with liquidity, but the size I trade in isn’t really a problem,” Keith said. “I think it’s when you have bigger trades, you get a concern there.”
For larger investors, another trick to circumvent liquidity issues is to deal in more liquid synthetic securities such as derivatives contracts, which can be used to bet on the credit quality of a company without having to deal with the same liquidity problems of the bond market.
Douglas Peebles, chief investment officer and head of AllianceBernstein fixed income, says he finds himself using more derivatives. These allow buyers to invest in the same underlying assets, but in many cases, they can be assured of more liquidity that the actual bond. Bond guru Bill Gross, who runs the world’s biggest bond fund, also concedes that he has begun using derivatives in his Pimco Total Return Fund.
Peebles has also shifted the way his trading desk works. His traders now have experience in independently pricing the debt securities they’re looking to buy and sell, reducing reliance on dealers to provide fair prices for trades.
“Before, you could go into the marketplace, and go ask five guys for the price of a bond, and get five similar prices. Now, we need to know the price,” he said.
Assessing the inherent value of a bond also includes knowing the price premium of liquidity. There's a growing gap between which bonds are liquid and which ones aren't, so the more liquid a bond is the higher the price tends to be, and the lower the yield.
A November Goldman Sachs report estimates that the premium that a bond pays over Treasurys is roughly 10% larger when a bond is illiquid, a large increase over pre-crisis levels. Shown the other way, liquid bonds on average yielded about 0.1 percentage points less between 2011 and mid-2013, according to BlackRock. That may not seem like much, but in a low-rate environment, every basis point counts over the life of a bond.
As investors adjust to this environment, innovation is beginning to take shape. Electronic-trading networks, which provide a more efficient connection between investors and dealers as well as other investors, have been slowly catching on (Read about MarketAxess as a case study). Such platforms run the gamut: some simply connect an investor to a dealer in a computerized equivalent of a phone call, while some open up the possibility of trading between all investors and all dealers at the same time.
Market participants have also been gravitating toward a variety of new market structures that redefine how corporate bonds trade (Rhode, of Tabb Group, puts these new structures into three groups).
The bottom line is that bond investors are getting used to the idea that liquidity has dried up. And here’s where the rubber meets the road. If all is calm in the bond market, with dependable and reliable flows into and out of bond funds, investors can methodically work around the issue. In that sense, a robust secondary market is simply a luxury.
But if there’s a mass exodus from the market, a functioning mechanism to trade bonds is necessary. Retail investors pulled money from corporate bond funds over the summer of 2013, forcing the sale of underlying assets, as the Federal Reserve contemplated scaling back its bond-buying program. When big bond investors had to sell into a down market, inconsistencies in the pricing became more exaggerated (See how investors fled bond funds this summer ).
The 10-year Treasury note, a benchmark often used to price sectors of the corporate bond market, recently traded near its highest level in over two years, though the corporate bond market recovered quickly from the summer selloff. If that sentiment again reverses -- a subject of much discussion due to shifts in monetary policy as well as any number of other market factors (see: the Great Rotation debate) -- a healthy trading mechanism is a necessity.
A solution may prove difficult because the bond market itself is fragmented, with issuers of many different sizes each selling specific types of debt. That was the case long before the financial crisis, but in the end the whole market may need to evolve, says Richard Prager, head of trading and liquidity strategies at BlackRock. The firm has been testing an internal bond trading platform (Read about BlackRock's Aladdin bond-trading platform). If trading in the bond market is to become like trading in the stock market, the adaptation has to begin with issuers, who could streamline the way they issue debt, with all of the other groups of market participants pitching in.
“This is a journey,” says Prager. “This is not an overnight market structure shift. I don’t know if this a three-year, five-year, or decade-long journey. In the equity market it took a decade to change.”