Another Investor Calls Illiquidity a Myth to Repeal Rules

Krishna Memani
OppenheimerFunds chief investment officer Krishna Memani. Photographer: Ramin Talaie/Bloomberg

Warnings of a liquidity crisis in the bond market are a myth created by Wall Street in hopes of repealing regulation, said Krishna Memani, the chief investment officer of OppenheimerFunds.

Bond buyers, who currently have no incentive to buy, will eventually step up when the market declines and owning debt becomes more lucrative again, Memani, whose firm oversees $235 billion, said in an interview.

It’s a view that’s gaining traction among money managers and even some bankers, as the Federal Reserve prepares to raise interest rates as early as next month. Memani has been preaching for months that volatility in bond markets is misunderstood and that price swings reflect changes in monetary policy, not illiquid markets.

“Everyone is talking about it as if the whole world will come apart because there are billions that have gone into this market, so all of a sudden billions will leave,” said Memani, whose firm is based in New York. “Spreads will widen, but it doesn’t mean the market won’t function. There will be investors available in the marketplace who will provide the other side of the trade.”

Memani and other skeptics, such as Bianco Research’s Jim Bianco, are responding to warnings from bankers and investors that the ability to buy and sell bonds without affecting prices has deteriorated in the wake of the 2008 credit crisis. Some have blamed new regulations that have made it more expensive or difficult for banks to hold bonds on their balance sheets, especially a provision of the 2010 Dodd-Frank Act known as the Volcker Rule that restricts banks’ ability to trade with their own money.

‘Warning Shot’

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon, among bankers who have raised concerns that there is a lack of liquidity in Treasury markets, said wild gyrations last October should serve as a “warning shot” to investors. Diminished liquidity in certain bond markets may lead to the next market crisis, Blackstone Group LP CEO Steve Schwarzman said in June.

The idea of a liquidity crunch has been pushed by Wall Street and investment firms with disproportionately large assets under management, Memani said in the phone interview. Dealers have propagated the narrative to get regulators to scale back the changes requiring higher capital levels, he said.

Revenue from fixed-income trading at the 10 largest global investment banks was $69 billion last year, less than half what it was in 2009, as activity dropped in some markets and new rules were implemented, according to industry analytics firm Coalition Ltd. Fixed-income revenue fell again in the first half of this year at the biggest banks, including JPMorgan and Goldman Sachs Group Inc.

‘Bit Shrill’

“Saying that it’s a structural problem for the market because people have piled onto high-grade bonds I think is probably overstating the market dynamic,” Memani said. “If they can convince the Fed and other regulators, they can get relief on Dodd-Frank. That’s what they want more than anything else.”

The chief economist at the mutual fund industry’s biggest trade group echoes his sentiments. Wall Street broker-dealers created the narrative to help motivate them to lobby to pull back the Volcker Rule, the Investment Company Institute’s Brian Reid said in an interview.

Bianco at Bianco Research in Chicago, has said that ultra-low interest rates are in part to blame for some of the gyrations bond markets have seen.

‘Epic Collapse’

“You want to shove rates down to zero, people are going to make big bets because they don’t think it can last,” Bianco said in June. “Every move becomes a massive short squeeze or an epic collapse.”

The tone regarding liquidity has gotten “a bit shrill,” said Richie Prager, head of global trading at BlackRock Inc., the world’s largest money management firm. While the liquidity dynamic has changed, the conversation has been underscored with “some sort of expectation that the regulators are going to roll back the clock,” Prager said. “We don’t think we’re going back in time.”

Some bank executives agree that concern about liquidity is overdone. While there are challenges in the evolution of the market, “to say there’s some sort of big problem I would view as somewhat extreme,” Steve Zamsky, Morgan Stanley’s global head of credit, said last week.

Transaction Costs

Memani said lower dealer inventories of bonds, cited by some as evidence of a coming liquidity crisis, are the wrong number to look at because trades that were reported in them weren’t available for client trading anyway

The average trading volume in Treasuries and corporate bonds is higher in the last year than over the past five years, and the cost to transact, as measured in bid-ask spread, is lower than it was in 2010, according to data compiled by Bloomberg.

If there has been a decrease in willingness to trade, it may be tied to the shrinking compensation investors get for owning bonds -- they can less afford to shell out for Wall Street’s trading fees, according to ICI’s Reid.

Yields on benchmark 10-year U.S. government debt have dropped to about 2.16 percent from about 6 percent 15 years ago and 9 percent 20 years ago. In 2012, they dipped to a record low of 1.38 percent. Yields across fixed-income products have fallen, with the Bank of America Merrill Lynch Global Broad Market Index reaching a low of 1.33 percent this January.

With rates that low, buyers who will step up in a downturn just aren’t apparent yet, said Memani.

“Right now they haven’t shown their hands because the credit cycle or interest rate cycle hasn’t moved much,” he said. “There’s nothing to do.”

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