As Good as It Gets
In recent days, bond market liquidity is often perceived as alarming and has also become a scapegoat for the recent major price losses, particularly in US high yield bonds. Yet at the same time, 2015 will be marked in history as just another record year for new corporate bond issues. A paradox?
"As good as it gets" is a US comedy from 1997 in which the leading actor Jack Nicholson does what he does best – play a grumpy, obsessive-compulsive character who is always teetering on the edge. Even though it is clear from the beginning that there will be a happy ending, the characters follow an unexpectedly rocky road to reach there.
The US Fed has also experienced difficulties exiting its quantitative easing. Nonetheless, after overcoming a few road bumps, it hiked rates for the first time in nearly a decade. Tied to this hike are concerns about how such a monetary policy regime shift could impact the financial markets. Considerable rises in volatility in stock, bond, currency and even commodity markets have already been evident several times during the course of this year.
Fed Chair Janet Yellen will employ soothing rhetoric aimed at allaying fears associated with the historic decision, but the current policy of ultra-easy money will not be over with just one increase in rates. We instead can expect to see as many as four more baby steps in 2016. Bond trading liquidity will play a special role in this environment – liquidity in the sense of the opportunity to buy or sell securities in the desired volume, at the appropriate time, at low transaction costs and with a negligible effect on price development.
Key rate development in the US
High yield bonds, which have been under price pressure for some time and more recently to a greater extent, are a current case in point demonstrating that liquidity requirements can strongly impact financial market movements. USD-denominated bonds with a rating below BBB- or Baa3 have lost nearly 10% in local currency terms, or approximately the combined yield in the last two years, since their peak in May.
There may be dire consequences if the global bond market is not in equilibrium, because a financial market crisis resulting from insufficient liquidity will impact far more than just the bond segment of the financial markets.
One cause was the recent decline in commodity prices, primarily of oil and gas, which was a major blow to US issuers. At around 11.4%, the proportion of US companies vulnerable to the price of oil is relatively high. However, the US' positive economic performance, with core inflation's precision landing at exactly 2.0%, tends to favour issuers from other manufacturing sectors.
Not least for the lack of a better explanation, the bond markets' difficult liquidity situation is thus frequently cited as a trigger for price distortions. The fear is that a lack in demand for high yield bonds could result in another sell-off similar to that at the peak of the banking crisis in 2008. It is also cited that such fear should not be fully dismissed, as stricter capital requirements such as the Volcker rule that restricts investment banks' proprietary trading have resulted in a notable reduction in corporate bonds held in bank trading books.
This notion is also supported by the sharp increase in volatility often occurring at times of stress, but not by the correlation of individual issuers' credit risk premiums which remained rather stable as measured by credit derivative index tranches.
Volatility of swaptions on the US CDX high yield credit derivative index
Source: Morgan Stanley
On the other hand, 2015, unaffected by liquidity bottlenecks, will be marked in history as a record year for new issues. The more than USD 2 trillion in industrial corporate bonds newly placed on the primary market worldwide since the beginning of the year indicates a high level of supply, but not an overhang. The ECB's remarkably expansionary monetary policy, which particularly enables above-average rated issuers to take on debt at practically imperceptible interest rates, is certainly very welcome to them and is a major contributing factor to the flood of new issues that have persisted for years. Not all unsurprisingly, it is also worth noting that more US firms than ever are tapping the European capital market.
At USD 71.4 billion, the issue volume of reverse Yankees is at its highest since 2004. This implies that if it is more attractive for US companies to take on debt in Euros and then convert the bond proceeds back into US dollars, then it might also be more inviting for European investors by the same token to buy bonds issued in US dollars and hedge the foreign currency risk. As the ECB is itself a buyer of sovereign and other bonds qualified for their purchase programme, and thus artificially keeping interest rates low through supply shortage while also holding both institutional and private investors at bay, the demand for corporate bonds seems to be secured.
It can be assumed that the level of primary market activity will remain high next year in order to (1) finance the takeover boom, which also resulted from the prevailing low interest rates, (2) fund the increasingly popular special dividends, and (3) fund the increasingly frequent share buyback programmes. Creditors should however view a strong orientation to shareholder interests with caution.
Despite the brisk issue activity, scores of investment banks are reporting disappointing results from their bond business. As there is no improvement in sight, cost-saving measures and job cuts will swiftly follow. The US securities trading firm Morgan Stanley recently suffered such consequences and laid off around half of its European bond-trading staff. Furthermore, Goldman Sachs sees little hope of an improvement in profitability in the bond segment any time soon. It appears increasingly difficult to broker between bond sellers and buyers without having to keep the bonds on the trading book temporarily. Since, however, it is usually difficult to draw a clear line between client business and proprietary trading at investment banks, it is also difficult to say with certainty whether the slump in investment banking earnings that we continue to see is a result of declining client business or the decreased revenues from proprietary trading which is no longer tolerated by regulators.
USD high yield turnover volume
Source: Deutsche Bank
There may be dire consequences if the global bond market is not in equilibrium, because a financial market crisis resulting from insufficient liquidity will impact far more than just the bond segment of the financial markets. According to a Financial Times article, Barclays and UBS analysts examined mixed or balanced funds that invest in both bonds and shares to see which stocks such funds would sell, in case of unit redemptions, if they were unable to sell down bonds. To exacerbate the situation, the sharp rise in refinancing costs resulting from the heavily declining bond prices would also have a negative effect on the equity market. Not least the latest report published by the IMF is dedicated to assessing the implications of lacking liquidity in the financial markets and concludes that larger corporate bond holdings by funds could increase the fragility of the financial System.
The 20 largest USD high yield issuers
Source: Bank of America/Merrill Lynch indices
For several years, there has been a trend of investors concentrating their money on fewer funds and ETFs, most evident in the impressive growth of selected ETFs. Nevertheless, whereas large-volume high-yield ETFs such as the USD 15.4 billion BlackRock HYG and the only marginally smaller State Street Investors JNK (USD 11.9 billion) enable investors to trade ETF shares on a stock exchange, it is a lot harder for these ETFs to in turn trade bonds in sufficient size. In order to track their respective benchmarks such as an iBoxx index or a Barclays index, these ETFs often invest in issuers which account for a larger share of the respective benchmarks and are thus more representative of the market.
Unlike equity ETFs, the two high yield ETFs mentioned are not cheap with fees of 50 and 40 basis points respectively. It is therefore no surprise that such ETFs often considerably underperform their benchmarks.
Some investors accept the performance disadvantage in exchange for fast reaction in an asset class that otherwise requires a high level of specialist knowledge and an established market access. However, this ability to manoeuvre is neither guaranteed nor – from the investor's point of view –always necessary. The majority of institutional investors have allocated between 60% and 80% of their portfolios to fixed-income securities, which primarily serve to provide a continuous base income. Only a small portion of that fixed income investment is used to adjust the portfolio for market movements or changes in objective. A less liquid – or even illiquid – base portfolio component may in fact have additional benefits for investors.
One example is the favourable treatment of long-term infrastructure financing under Solvency II. However, if it were not possible to quickly dispose troubled bonds when issuer credit risks surface, the traditional portfolio management approach would not work. Instead, a buy-and-hold strategy requires impeccability right at inception. The typical benchmark orientation of most investment strategies is certainly not applicable in this context.
The fact that the increasing illiquidity of bonds, especially the heavyweights in funds or ETFs, could represent a potential threat that may be systemically important in a similar way to the SIFIs, has not escaped the attention of the supervisory authorities either. However, as investment vehicles such as funds or ETFs, unlike banks, invest on behalf of their investors on a trust basis, they cannot simply be regulated in the same way as financial institutions.
People pinning their hopes on the European MiFID may have their patience tried. MiFID II, designed to provide more transparency in bond pricing and derivatives trading and originally scheduled to be introduced in 2017, is currently not expected to take effect before 2018 – eight years after it was first proposed.
The lack of transparency in the seemingly archaic telephone trading, though still commonplace in the bond business, and the aforementioned structural changes in the bond market preventing proper functioning have also been noted by exchange operators such as Deutsche Börse, the London Stock Exchange (LSE) and the US Intercontinental Exchange (ICE).
Deutsche Börse, Germany's largest exchange operator, ended its involvement after only a short period in the promising electronic trading platform Bond Cube, which subsequently filed for insolvency. In contrast, the ICE recently shelled out as much as USD 5.2 billion to acquire Interactive Data Corporation (IDC), which specialises in analytics and price data for non-exchange tradable securities that are difficult to value. The LSE acquired index provider Frank Russell for USD 2.7 billion in 2014, as a means to enter the US market and ETF business. Although licensing data for the exchange operators provides a stable and profitable source of income, the fragmentation of the bond market emerges to be the largest hurdle to functional bond trading.
It appears that the challenge cannot be rectified without outside intervention. Pooling buyers and sellers on one or more electronic trading platforms would help to raise trading turnover and therefore to remove liquidity bottlenecks. Such measures would also be in line with the supervisory requirements on best execution, which include obtaining prices from multiple trading partners. At the same time, a better overview of turnover and related data would be very useful to market participants in forming their own price expectations, and thus also in turn stimulate trading turnover.
Market liquidity is not the only would-be beneficiary. The usual process for placing new issues also presents a well known problem for investors, as the banks running the issues initially offer higher yield concessions to lure potential investors into a deal. However, these often completely disappear closer to the time books close and are at the end only vaguely quoted with an "a" for area. On the other hand, subscriptions to new issues are often times submitted without limits. With issuers regularly active on the capital market, a functional secondary market could then offer the opportunity to switch to existing bonds, if a new issue ultimately proves too expensive.
The way of pricing new issues is not the only reform needed. The outright lack of transparency in the allocation process also appears as a relic from a dark capital market past, and would be for instance unfathomable for equities issues. It is inconceivable that the financial authorities tolerate such practices for such a long time.
- The dramatic interventions by central banks worldwide distort asset pricing otherwise based on fundamentals. The now diverging US and European monetary policies exacerbate the problem.
- Bond market liquidity has depleted but not to a critical extent given the ongoing and impressive demand for new issues.
- Capital market turmoil as experienced repeatedly in 2015 may in fact offer an advantage for medium to long-term oriented investment strategies.
- Pooling transactions on a few electronic trading platforms creates greater price transparency and eliminates structural market inefficiencies.
Pricing transparency has a positive impact on trading.
After much discussion on the pros and cons of the US rate hike, an unanticipated side effect could be the overdue reform of bond trading. That's as good as it gets.
 In nominal terms, the portion of issuers from the Exploration & Production, Oil Field Equipment & Services and Oil Refining & Marketing sectors registers 11.37% on the BoAML high yield index, but measures only 7.8% at market value.
 See also "Sales of corporate bonds top $2tn", Financial Times, 3 December 2015, p. 17.
 See also "Equity with hybrid fund exposure at risk in bond market rout", Financial Times, 3 November 2015, p. 22.
 See also IMF Global Financial Stability Report (GFSR): Vulnerabilities, Legacies, and Policy Challenges. Risks Rotating to Emerging Markets. October 2015.
 iShares iBoxx $ High Yield Corporate Bond ETF.
 SPDR Barclays High Yield Bond ETF.
 SIFI: Systemically important financial Institution.
 Markets in Financial Instruments Directive.
 See also "European MiFID II legislation set for year-long delay", Financial Times, 26 November 2015, p. 20.
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