It’s getting harder to trade bonds. Hours, sometimes days can go by before investors can complete a transaction. That’s not dissuading them from piling into the most-illiquid debt out there.
Junk-bond investors are earning practically nothing extra to own older, smaller bond issues that don’t typically trade as often as bigger, newer debt offerings, according to Barclays Plc data. The gap has collapsed to almost zero from a 1.05 percentage point premium for the less-liquid notes in the fourth quarter of 2011.
That means bondholders aren’t really being compensated for the risk that there might be no one who wants to buy their obscure securities if demand dries up and they’re forced to sell. They’re not worrying about that now, though, with volatility at historic lows and cash flowing into credit markets amid a sixth year of unprecedented Federal Reserve stimulus.
“The ‘roach motel’ dynamic is as pernicious as ever,” Pacific Investment Management Co.’s Christian Stracke wrote in a May note posted on the Newport Beach, California-based firm’s website. “Investors should beware of credit funds that offer daily liquidity where managers are reaching for yield and are not paying close attention to the prospective liquidity profile of what they buy.”
Since the end of March, investors have earned an average 0.09 percentage point more to own older, smaller bonds instead of larger, more recent ones, according to the Barclays data, which doesn’t take into account differences in maturity. That’s the narrowest yield gap for any quarter since the three months ended June 30, 2011.
This underscores the growing complacency among debt investors who aren’t seeing an obvious catalyst to derail a junk-bond rally that’s delivered 146 percent gains since 2008.
Unlike stocks, junk bonds are traded over the phone away from exchanges. Wall Street’s biggest banks have traditionally facilitated corporate-debt trades using their own money. They’re reducing this role now in the face of regulations making them hold more capital against debt holdings.
In the past, dealers would purchase bigger clumps of bonds than they could immediately sell, allowing investors to get out of positions even if a broker didn’t have a client on the other side looking to buy. That’s changed, and junk-debt trading has fallen as a proportion of the total amount outstanding.
The amount of below investment-grade bonds in the market has swelled by 54 percent since 2009, yet trading volumes have only increased by 34 percent in that period, according to Bank of America Merrill Lynch and Financial Industry Regulatory Authority data.
Many of the biggest investors, including Oaktree Capital Management LP’s Howard Marks and Apollo Global Management LLC’s Leon Black, have been advocates of investing in harder-to-trade debt, with one major caveat: Funds must be prepared to hold on to the securities.
Even Stracke, global head of Pimco’s credit research group, isn’t against the idea of less-traded debt. From his note: “Pimco is generally an advocate of the buy-and-hold strategy in credit investing,” as long as investors won’t need to exit those investments during a rough patch and are getting paid appropriately for the lack of flexibility.
That last point is where it gets tricky.
With the yield gap between the illiquid and the liquid notes disappearing quickly, it’s hard to see the benefit investors are getting.