What No One Ever Says About Corporate Bond Market Liquidity
Everyone’s worried about bond market liquidity. That much we know. Whether it’s high-yield corporate bonds sold by junk-rated companies or the ultra-safe Treasuries sold by the U.S. government, investors’ ability to buy and sell these securities without "overly" affecting prices has moved to front and center of the proverbial market concerns.
The causes, we hear, are myriad. Regulation that has curbed banks’ ability to hold vast sums of bonds on their balance sheets is often blamed. We are also told that years of low interest rates have herded investors to the same positions, spurring billions of dollars worth of inflows into global bond funds. The worry is that should those inflows reverse, bond prices could hit an air pocket and face a rapid descent.
There’s a long list of potential solutions to the problem. A shift toward electronic trading was once supposed to save a corporate bond market in which many trades are still done over the phone (although so-called electronification has apparently impeded liquidity in the U.S. Treasury market). Exchange-traded funds that give investors the ability to instantly dart in and out of positions are promoted as a quick fix for a longer-term problem. BlackRock, the world's biggest asset manager, is pushing standardized bond issuance and wants to delay trade reporting for corporate debt.
All these solutions miss the point, however. None focus on the real reason behind deteriorating liquidity, which is that vast swaths of the corporate bond market have simply been cornered.
Corners have a long history on Wall Street. They very often do not end well.
Take, for instance, the corner mounted by Clarence Saunders, founder of the Piggly Wiggly grocery stores that once proliferated across the American South. Saunders bought up 196,000 of the 200,000 outstanding Piggly Wiggly shares as he sought to fend off an attack by short sellers. The corner collapsed after securities regulators gave short sellers extra time to settle their trades. Although stock market corners have since been outlawed, they still pop up here and there: JPMorgan’s accidental cornering of a credit default swaps index back in 2012 ended in tears and a $6 billion trading loss.
The present corner in corporate bonds works like this: Big investors muscle their way into a corporate debt sale, often influencing the pricing and terms of the new issue and buying large chunks of the resulting debt. Then they wait. They can make hefty profits simply by holding the new bonds before they are added to the benchmark indexes against which most investors are judged. The practice, according to Citigroup analysts, can add 20 basis points of annual additional returns at a time when it's difficult to outperform the overall market.
Beyond outperforming the benchmark, having sizable chunks of a new corporate issue locked up in big investors' portfolios creates an immediate squeeze upward in the price of the debt. Examples abound. When Verizon sold $49 billion worth of bonds last year, analysts estimated that investors lucky—or powerful—enough to get a slice of the mega-deal made $2 billion in paper profits in just 24 hours. In April, Fortescue Metals sold $2.3 billion of bonds that went on to gain $63 million in value in two days.
"In the bigger deals, [bankers] are going to get the larger funds to take down the balance. Those deals can hinge on the big funds. They might say that they're in at 'x' spread, so that could put a floor on what the deal will come at," says David Schawel, portfolio manager at Square 1 Bank in Durham, N.C.
If you can do the Corner, it’s free money. It also leads to a virtuous cycle for the big investors involved. Gobbling up corporate bonds allows you to beat your benchmark, so investors give you more assets. As your assets under management grow, so does your clout in the market, enabling you to buy even more debt.
"The asset managers are addicted to new issues. It's the candy that they need every day," says Paul Reynolds, a former Citigroup trader who founded the now-shuttered bond trading platform, Bondcube. "As a process, new issue allocations could be a lot better."
While it's not unusual for investors in new-issue deals to be compensated for the risk of buying new securities, the rewards for doing so have increased as the biggest buy-side players get bigger and competition for higher-yielding assets intensifies. A Bank for International Settlements paper released last year estimated that the bond holdings of the 20 biggest asset managers increased by $4 trillion in the four years immediately following the crisis. Back in 2002, the top 20 managers accounted for 50 percent of the total assets under management assets of the 300 biggest investment firms. By 2012—at the end of the BIS's data series—the proportion had climbed to 60 percent.
No one likes to talk about the Corner in corporate bonds. Dealers don’t like to admit that big players on the buy side now have more pricing information and influence than dealers do. The big buy-side players don’t want added scrutiny at a sensitive time for the asset management industry; many have been struggling to fend off additional regulation that would put them on a par with "too big to fail" banks, as well as rules that could impose exit fees on funds that promise instantaneous access to illiquid assets.
But the Corner is real, and it has consequences.
Cornering a market is tricky because the more successful you are at doing it, the more you become the market. It moves as you move. As you buy, prices move disproportionately upward. When you sell, prices can fall quickly and dramatically. The Corner is not a problem as long as big investors continue to buy and hold corporate securities. The Corner will become a problem if something—such as an interest rate rise or nervous retail investors—sparks a forced and sudden rush for the exits.
We know that everyone is worried about bond market liquidity and the possibility that prices will tumble excessively as investors rush to sell. No one is publicly worried about the corollary to that argument, which is that low bond market liquidity has already helped force prices much higher than they would otherwise be.
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