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Liquid is as Liquid Does
Jason D. Edinger, CFA
Much has been made in recent years of an alleged dearth of liquidity in U.S. corporate bond markets. From media personality diatribes to asset manager commentaries to the general financial blogosphere, there is no small number of pundits with an opinion on the subject. Interestingly, many of those opinions are suspiciously similar, and whenever a heavy consensus begins to build around a particular market topic, the inner contrarian in me emerges to seriously question the legitimacy of the topic du jour. Is there truly a “liquidity crisis” in the markets or is it all a bunch of hot air? The current liquidity picture in U.S. bond markets is murky and unclear. Empirical data do indicate that structural changes have reduced the degree of traditional liquidity provided by the marketplace. However, except in isolated instances of extreme stress and panic, long-term strategic investors are as prepared as ever to harvest any risk premiums associated with reduced levels of liquidity.
The consensus has been building for several years, and the prevailing dialogue surrounding the topic primarily involves the role of market making dealers on Wall Street. As a refresher, most bonds do not trade on an exchange like stocks. Instead, they trade over the counter (OTC) which means that transactions are conducted on an ad hoc basis whereby a would-be seller is connected to a would-be buyer via an intermediary or dealer. OTC transactions lack transparency, as only the buyer, seller, and dealer are privy to the bid (purchase) and ask (sale) prices. This decentralization means that dealers can offer different bid-ask prices to different market participants, and thus the price discovery process is much more iterative and incremental, in stark contrast to the nearly instantaneous and transparent stock markets.
Historically, dealers have been essential to bond market liquidity in that they play the key role of market makers. In order to be considered a legitimate market maker, a dealer must be willing to take a position on either side of almost any trade. In other words, it must be willing to quote both a bid and an ask for a given bond, and it must be willing to absorb that bond onto its own balance sheet if necessary. In exchange for these services, and for assuming the associated risks, dealers quote a different price to buy and sell a security, hedge the position, and capture the resulting profit known as the bid-ask spread.
What these dealers really do is provide on demand liquidity to buyers and sellers of bonds. Without dealers, investors in all but the most liquid issues would struggle to dedicate capital for any extended period. In terms of trading bonds, liquidity essentially means the ability to buy or sell a particular issue without negatively affecting the price. For most of the bond market’s history, dealers have been present and willing to make a market in even the most obscure, low profile, off-the-run bonds, rare exceptions being one-off panic episodes such as the Global Financial Crisis (GFC) of 2007-2009. This has provided the necessary liquidity to facilitate trading in the massive bond market without the exchanges commonly used to trade other financial instruments such as stocks.
And here is where the discussion surrounding the evaporation of liquidity in the bond markets gets tricky. We are witnessing structural developments in the bond markets that are changing the nature of how these securities are bought and sold. Clearly, bond turnover and trading volumes have steadily declined in the years following the GFC. Also, dealer inventories have fallen off precipitously from their peak levels in 2007. But…does all this mean that there is necessarily and unequivocally an impending liquidity crisis in the broader bond markets? Maybe, maybe not. In order to find out, let us address each of these developments in sequence:
- Structural Changes in Bond Markets: One area of profound change in bond markets involves government regulation. In particular, the Volcker Rule and its larger parent, the Dodd-Frank legislation. The Volcker Rule has been particularly onerous, as the law effectively outlawed proprietary trading by any federally insured bank, most of which also acted as large market makers. One of the bigger unintended consequences of the legislation has been the removal of an important source of liquidity from the market almost overnight.
Additionally, exchange traded funds (ETFs) and mutual funds have emerged as powerful players in the space, and this has changed the way liquidity is provided and used. These vehicles provide immediate and/or daily liquidity – meaning investors can get their money back within a day – while the portfolio securities might not be as readily liquid. This mismatch in liquidity presents a very real risk for a run on any one fund, as it may be unable to sell its securities quickly to meet investor demand for liquidity. Witness last year’s demise of the celebrated Third Avenue Management’s junk-bond fund, an event which justifiably sent shock waves of angst and concern rippling through the bond markets.
- The Mixed Signals of Trading Volume and Bond Turnover: In both the U.S. investment grade (IG) and high yield bond markets, trading volume has trended directionally higher in recent years, roughly doubling in size since the GFC:
|Investment Grade||High Yield||Total|
Ordinarily, this would be good news from a liquidity standpoint. Traditionally, more and larger transactions would indicate a deeper, more liquid market. However, volume by itself offers only an incomplete picture of the true liquidity in the market. Bond turnover is a more mathematically comprehensive and robust measure of liquidity. While volumes have increased materially, bond turnover has actually declined as a result of historically high new bond issuance, effectively reducing the overall liquidity level in the market.
- Decline in Dealer Inventories: This case for lower liquidity principally involves dealer inventories. Prior to the Volcker Rule, most big Wall Street banks would hold large quantities of corporate bonds and other securities as inventory on their own balance sheets, much like a car dealership maintains an inventory of new and used cars for buys and sales. One of the many consequences of the Volcker Rule is that banks have been forced to shrink or even eliminate their bond inventories. The size and depth of the markets they make for traders has shrunk in lockstep.
What this means is that the institutions which have historically made markets in bond trading do not have as many bonds on hand, and fewer bonds to trade necessarily means lower liquidity. As the cost to hedge bond positions continues to skyrocket and political regulation continues to assert itself, it is unlikely that the trend of declining dealer inventories will reverse any time soon.
The preceding three phenomena paint a pretty bleak picture about the state of liquidity in the bond markets. There are dozens more that further underscore the point, far more than I could possibly cover in this note. It is understandable to succumb to alarmist fears and concerns. The facts are irrefutable. However, these data do not provide a complete picture of market liquidity and in order to make a proper assessment, we must look beyond the numbers and focus on the implications for investor portfolios.
Human beings are resilient. We have an uncanny knack for adapting to changing conditions around us. Bond markets are no different. As the calls for an impending liquidity crisis in the space ring ever more loudly, dealers and investors have used their balance sheets more efficiently. A good example is the emergence of electronic trading platforms in the markets. Historically dominated by OTC trading rules, more corporate bonds are trading on electronic platforms than ever. According to the U.S. Treasury, almost 20% of investment grade (IG) corporates are currently traded electronically. E-trading is associated with higher trading volumes and smaller bid-ask spreads, both of which underscore better liquidity.
Additionally, as different investment vehicles have entered the bond space (mutual funds, closed-end funds, and ETFs) they have provided alternative means of liquidity. For example, bond ETFs allow investors to achieve immediate liquidity without a negative impact on price (assuming the market is not in a full- blown panic). This is essentially the flip side of the argument presented earlier about the liquidity mismatch inherent in ETF structures. Other institutional players have also entered the bond market, attempting to balance the supply-demand equation. As the demand for liquidity increases, we could see newer and different entities stepping in to the market to meet that demand with adequate supply, thereby providing additional sources of liquidity to investors.
Lastly, with Federal Reserve Bank interest rate policy in the spotlight, it is worth noting that a slight uptick in rates or rate volatility should be beneficial for bond market liquidity. With historically low rates in recent years, crowded trades have led to higher correlations among and between asset classes. As interest rates rise and/or volatility spikes, dispersion amongst bond sectors and segments returns, facilitating more bilateral trading. Additionally, more attractive spreads could encourage new traders to step in and allocate capital to profit from the widening. Moreover, if rates were to rise steadily over time, the bond market would likely see renewed interest on the part of powerful investors currently on the sidelines – including insurance companies, pension funds, and sovereign wealth funds. Hedge funds and other specialists could also begin trading actively in the space, leading to increased volumes and thus greater liquidity. Finally, if rates begin to increase materially, the cost of issuing new capital would also increase, dissuading corporations from issuing new bonds and forcing investors to rely more heavily on the secondary market for bond exposure, which also bodes well for liquidity.
Liquidity risk management is a critical part of our portfolio management process. When evaluating a new or existing bond manager, we conduct extensive due diligence to ensure that the manager has adequately considered liquidity in its risk management process, and that the proper mechanisms are in place to either capitalize on or insulate the portfolio from liquidity risk. At the aggregate portfolio level, we go to great lengths to ensure that our asset class and manager decisions are in balance with the risk/reward associated with differing levels of market liquidity.
While it is clear that the bond liquidity picture has changed materially in the wake of the GFC, no one knows exactly what is in store for market liquidity. However, we feel that concerns have been exaggerated and overhyped. We are thus cautiously optimistic that a new, different liquidity regime has already begun to emerge and supplant the old school, and we will monitor its evolution closely. In any case, being long-term strategic investors, thus not driven by the pressures of short term trading, we are in a strong position to exploit and profit from illiquidity premiums that may exist in global bond markets.