Click on “send” and you will soon own something. The ease and speed of communicating transactional information has reached a level where many do not give a second thought as to the other side of that transaction. The world is my oyster.
In today’s bond market many observers are beginning to comment on market liquidity concerns as some of the rules of the game have changed and some of the market dynamics have shifted as well.
Bonds trade a little differently than stocks. With stocks you have market makers who stand willing to buy or sell a certain number of shares at a price. In the old days, they did this exclusively on the floors of the various stock exchanges. Today most of it is electronic. The spread between bid and ask may widen with higher volatility or an imbalance of orders on one side of the equation.
To trade bonds back in the old days, you would have to use a telephone and call several bond dealers to ask each of them for a bid or an offer. Today much of this is done quickly and efficiently through electronic exchanges with widely traded issues such as US Treasury bonds enjoying great liquidity. Many bond issues, however, don’t actually trade as often as most stocks and US Treasury bonds. So there may not be a buyer sitting around waiting to buy your bond at his/her bid price. Parts of the corporate bond market, mortgage bond market and municipal bond market are naturally less efficient and less liquid, meaning that it may take time to do a trade (during which benchmarks can move) or it may take a price concession to do a trade. Over the years, bond dealers have often acted as principals to bond trades when ready buyers could not be quickly found. This means that they buy bonds for their own account with the intention to sell them to a client or another dealer at some point in the future, hopefully at a profit.
With the financial crisis of 2008 endangering the viability of our biggest banks, new regulations were promulgated calling for banks to use less of their capital for market-making activities such as buying bonds for their own account. Ask any major bond manager about Dodd Frank and you will hear about the greater difficulty these managers have in selling and buying bonds.
Now factor in the both the tremendous flows of cash into bonds since 2008 and the zero interest rate policy that has prevailed since then. The flows into bonds meant higher demand and the super-low interest rates invited borrowers to issue more bonds. The result is that the corporate bond market, in particular, has more than doubled in size since just 2008. At the same time turnover in the corporate bond market has declined since 2008.
So what’s the problem? The fear is that sudden spikes in trading volume combined with less market-making dealer capital available will roil the bond market, causing prices to move quickly and without discretion in a disorderly fashion. If a sovereign wealth fund or large hedge fund suddenly wants to sell bonds, to whom will they sell and at what price? The bond market’s ability to handle unusual volume will likely be tested at some point and bond managers have been readying themselves for this test by making sure they have sufficient liquidity in their portfolios. One manager we know has categorized their bond universe into 3 categories. The first category is “risk-off” or highly liquid bonds such as US Treasury and Agency bonds. The second category is “bendable”, which includes investment grade corporate bonds and asset backed securities. These are considered to be potentially volatile, but not disastrous. The 3rd category is “breakable” which includes high yield, emerging markets and non-Agency mortgages. Bond managers have gravitated towards “bendable” and “breakable” assets because that’s where the yield has been. Hopefully your bond manager has sufficient exposure to “risk off” assets in the event that liquidity becomes an issue for the bond market.