The Bank of England Just Learned a Lot About Bond Market Liquidity
You can't always get what you want.
On Tuesday, the Bank of England didn't manage to buy all the gilts it wanted at a reverse auction — the first such shortfall since it began its bond-buying program back in 2009. The 'uncovered auction' happened as investors proved reluctant to part with their holdings of longer-dated U.K. government bonds and could create a headache for policy makers seeking to offset the economic impact of the Brexit referendum by lowering borrowing costs.
The central bank snafu sparked a lively discussion over whether the BOE is reaching Japan-like technical limits in its sovereign-bond purchases or simply suffering from a temporary summertime trading lull. While the fact that today's auction proceeded without incident suggests the latter, the hiccup still speaks to a truism of the long-running debate over the ease of trading in the bond market; namely that a lack of liquidity is the flip side of a rampant search for yield amid low interest rates.
Or as Peter Boockvar, chief market analyst at The Lindsey Group, quipped: "A funny thing happened on the way to more QE from the BOE as some investors wised up and decided to not sell their longer-dated paper... After all, why give up higher yielding bonds when the alternatives with the cash are pathetic?"
Years of accommodative monetary policy have encouraged investors to seek out returns wherever they may find them. That's made longer-dated government debt of particular interest given its relatively higher yield, perceived safety, and suitability for investors such as pension funds and insurers with longer-dated liabilities.
With returns scarce and correlations high, many investors have also found that chasing inflows, as opposed to value, has become a more reliable way of generating superior returns. That behavior has become particular prevalent in parts of the bond market, where demand for assets often far exceeds supply — creating an almost guaranteed pop of outperformance for investors lucky enough to get the assets through auctions and other sales processes.
Investors in longer-dated paper knew there was a willing buyer on Tuesday, when the BOE set out to buy 1.17 billion pounds ($1.53 billion) of gilts due in more than 15 years. Instead the U.K. central bank found itself offered just 1.118 billion pounds worth of securities, with some investors even demanding the BOE pay above-market prices for the privilege. The highest accepted price for the 4 percent bond due in 2060 was 194.00, compared with a weighted average of 192.152, for instance.
On Tuesday, "for whatever reason — the gilt market had insufficient liquidity to provide the BOE the amount of bonds they were looking to buy using their preferred mechanism," said analysts led by Hans Mikkelson, credit strategist at Bank of America Merrill Lynch.
They added: "We do think that the immediate decline in yields showcases why corporate bond QE is so bullish for credit spreads. When central banks want to buy in size in an illiquid market, such as the corporate bond market, they have to pay up significantly to even try to fill their desired size. This is true regardless of whether the pricing mechanism is BOE's preferred reverse auction or the ECB's bilateral negotiations."
The good news is that while the Bank of England failed to actualize itself as a real buyer of 1.17 billion pounds of longer-dated paper, it proved to be a very successful theoretical one thanks to the same mechanics that arguably limited its ability to wrest away securities from unwilling investors. "Because of the supposed possible scarcity now on long term gilts, yields are falling another 4.5 basis points to just .54 percent," noted Boockvar ahead of today's successful sale.
So you can't always get what you want. But if you try sometimes you just might find you get what you need — in this case, lower borrowing costs through a flattening of the U.K. yield curve.