Bond Buyers Forgot to Beware: Lisa Abramowicz

(Bloomberg) -- Wall Street executives have been warning for years about an impending bond-market liquidity crisis.

It’ll be a scary, terrible, dangerous thing, they’ve said, scarier still because no one knows how bad it will be, with cheap money still sloshing around the system and skewing traditional measures of market stress such as bid-ask spreads, order book depth and the price impact of trades.

William C. Dudley, the president of the New York Federal Reserve Bank, echoed those fears Wednesday, saying, “A clearer picture on liquidity conditions may only emerge as monetary policy is normalized.” His conclusion was regulators should be open to adjusting rules to improve liquidity conditions as long as they do not increase any threat to financial stability.

Liquidity is a murky concept. Not only is it unpredictable, it’s incredibly difficult to define. The International Monetary Fund had this insightful comment on the topic in a report this week: “It’s complicated.”

There is a remote possibility of a full-on liquidity crisis. In theory, some event would prompt investors who own trillions of dollars of riskier corporate bonds to question whether they will get their money back. And when they don’t know the answer, they’ll try to run. Except everyone else will be trying to run, too, and the whole system will break down.

But that’s the worst-case scenario. A simpler and less panic-inducing explanation for the current worries is that there is a sudden, collective case of bond buyers’ remorse.

Aided by the Fed’s easy-money policies, investors piled into riskier bonds thinking that they could enjoy large returns with an easy option to exit if things ever turned south. But risk is risk for a reason, and some investors flooded into debt they didn’t understand and couldn’t evaluate. Investors can’t have it both ways, and they have started realizing that dumping their bonds may not be as easy as they once thought.

Unlike stocks, much of this debt doesn’t trade all that much, and when it does, it’s traded on the phone and in emails, away from exchanges. Given the lack of volume, one big forced seller could more easily overwhelm the market and push prices much lower before even completing the sale.

To complicate matters, Wall Street has fanned the flames with its own self-interested argument, saying that overly stringent regulations have forced big banks to curtail their traditional role of greasing the wheels in the $8 trillion U.S. corporate-bond market. Without them, they’ve contended, there may not be any buyers until prices spiral so low, and borrowing costs soar so high, that companies can’t refinance and become insolvent, starting a downward cycle of misery.

There’s a certain amount of scare-mongering there. Other professional buyers exist, spending their days assessing the value of debt. Funds like Apollo Global Management, Oaktree Capital Group and Blackstone Group ostensibly have cash on hand, waiting for the right opportunity.

Also, these regulations have pushed risk out of the hands of these banks, arguably putting them in a better position to help, rather than exacerbate a crisis.

Instead, the risk has migrated to investors, including mutual fund buyers, who may have ignored what they were getting into. For them, that wait for a price bounce may feel like an eternity. Risky debt is risky debt, and by the time some investors realize that, they may have trouble at the return counter.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

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