Investors play their hand
The total amount of trades in the high-grade corporate bond market has actually increased in the last five years, which seemingly contradicts the idea that liquidity is drying up. But alongside that rise, trade sizes have shrunk markedly, indicating that investors trying to route their trades through Wall Street have
had to break up their trades to accommodate smaller balance sheets.
This change has given small firms an unusual advantage on Wall Street, where mammoth investors often have an edge because of their size.
Trade size
“I haven’t seen any problems with liquidity, but the size I trade in isn’t really a problem.” — Chris Keith, Adviser Investments
Chris Keith manages portfolios for individuals at Newton, Mass.-based Adviser Investments, which has roughly $2 billion in assets under management. When he’s in the market, he’s trading in smaller quantities than the major asset managers, which means he doesn’t risk overwhelming the Street with his inventory.
“I haven’t seen any problems with liquidity, but the size I trade in isn’t really a problem,” Keith said. “I think it’s when you have bigger trades, you get a concern there.”
For larger investors, another trick to circumvent liquidity issues is to deal in more liquid synthetic securities such as derivatives contracts, which can be used to bet on the credit quality of a company without having to deal with the same liquidity problems of the bond market.
Douglas Peebles, chief investment officer and head of AllianceBernstein fixed income, says he finds himself using more derivatives. These allow buyers to invest in the same underlying assets, but in many cases, they can be assured of more liquidity that the actual bond. Bond guru Bill Gross, who runs the world’s biggest bond fund, also concedes that
he has begun using derivatives in his Pimco Total Return Fund.
Peebles has also shifted the way his trading desk works. His traders now have experience in independently pricing the debt securities they’re looking to buy and sell, reducing reliance on dealers to provide fair prices for trades.
“Before, you could go into the marketplace, and go ask five guys for the price of a bond, and get five similar prices. Now, we need to know the price,” he said.
Assessing the inherent value of a bond also includes knowing the price premium of liquidity. There's a growing gap between
which bonds are liquid and which ones aren't, so the more liquid a bond is the higher the price tends to be, and the lower the yield.
A November Goldman Sachs report estimates that the premium that a bond pays over Treasurys is roughly 10% larger when a bond is illiquid, a large increase over pre-crisis levels. Shown the other way, liquid bonds on average
yielded about 0.1 percentage points less between 2011 and mid-2013, according to BlackRock. That may not seem like much, but in a low-rate environment, every basis point counts over the life of a bond.
As investors adjust to this environment, innovation is beginning to take shape.
Electronic-trading networks, which provide a more efficient connection between investors and dealers as well as other investors, have been slowly catching on (
Read about MarketAxess as a case study). Such platforms run the gamut: some simply connect an investor to a dealer in a computerized equivalent of a phone call, while some open up the possibility of trading between all investors and all dealers at the same time.
The bottom line is that bond investors are getting used to the idea that liquidity has dried up. And here’s where the rubber meets the road. If all is calm in the bond market, with dependable and reliable flows into and out of bond funds, investors can methodically work around the issue. In that sense, a robust secondary market is simply a luxury.
But if there’s a mass exodus from the market, a functioning mechanism to trade bonds is necessary. Retail investors pulled money from corporate bond funds over the summer of 2013, forcing the sale of underlying assets, as the Federal Reserve contemplated scaling back its bond-buying program. When big bond investors had to sell into a down market, inconsistencies in the pricing became more exaggerated (
See how investors fled bond funds this summer ).
The 10-year Treasury note, a benchmark often used to price sectors of the corporate bond market, recently traded near its highest level in over two years, though the corporate bond market recovered quickly from the summer selloff. If that sentiment again reverses -- a subject of much discussion due to shifts in monetary policy as well as any number of other market factors (see:
the Great Rotation debate) -- a healthy trading mechanism is a necessity.
A solution may prove difficult because the bond market itself is fragmented, with issuers of many different sizes each selling specific types of debt. That was the case long before the financial crisis, but in the end the whole market may need to evolve, says Richard Prager, head of trading and liquidity strategies at BlackRock. The firm has been testing an internal bond trading platform (
Read about BlackRock's Aladdin bond-trading platform). If trading in the bond market is to become like trading in the stock market, the adaptation has to
begin with issuers, who could streamline the way they issue debt, with all of the other groups of market participants pitching in.
“This is a journey,” says Prager. “This is not an overnight market structure shift. I don’t know if this a three-year, five-year, or decade-long journey. In the equity market it took a decade to change.”
PHOTO CREDITS FOR CHAPTER COVER IMAGES: Top: Getty images; Middle: Library of Congress; Bottom: Bloomberg
