By Patrick Faul, Director – Research, September 19, 2017.
“Mr. Godot told me to tell you he won’t come this evening but surely tomorrow.”- Samuel Beckett
Over the last several years, many bond market participants have waited impatiently for the arrival of higher rates. It is easy for all issuers to sell bonds when the biggest buyers do not make decisions based upon the rates of the bonds they are buying. When central banks do stop buying bonds to keep rates low, there is a good chance rates will actually rise, and sellers will find buyers to be more selective. The end of government intervention (Quantitative Easing) is eagerly awaited so that investors can go back to what they learned from their now-dusty finance textbooks.
While everyone waits for rates to move back to “normal” the bond market is experiencing the usual stretch for yield. This stretch has been exacerbated by the absolute low level of rates. Those who took the early plunge for yield and bought risky, illiquid bonds have been amply rewarded as yield desperation became more widespread. Bonds that had been widely believed to be illiquid traded easily. This is a normal part of the bond market and happens whenever greed temporarily overcomes fear.
As people take a deep breath and buy securities they wouldn’t buy a year ago, they know what’s coming. Experienced investors know how this will end; liquidity dries up in the market, bid-ask spreads widen, and credit spreads widen as potential buyers become more fearful. Sellers will liquidate their most liquid bonds to raise cash and pray that things return to normal before they receive the dreaded tap on the shoulder to sell those illiquid bonds. If their prayers don’t work, broker quotes on low-quality bonds and illiquid bonds will drop several points at a time as buyers are rewarded for waiting. Sellers will regret waiting to sell as they watch their illiquid bonds drop as other sellers find buyers and the buyers become more selective. Eventually, that too will end.
There are plenty of articles to read about duration risk and credit risk, but liquidity risk is often ignored by the financial press. Academic studies are fairly unanimous in finding that the most important factors in bond liquidity are the issue size and the recency of issuance. When the inevitable happens, buyers are most willing to buy the bonds that they know. Why would they buy part of a $250 million issue of bonds that was sold to eight different insurance companies seven years ago by “Consolidated Industries” and have not actively traded since then?
Broker-Dealer Trading Books
Bond liquidity has also been affected by the smaller amount of bank risk-capital that is allocated to the trading books of broker-dealer subsidiaries. As risk-capital has become scarcer, decisions about its allocation are made more carefully, particularly with regards to liquidity risk. Liquidity risk can rise dramatically with one breaking news headline. Trading books can be hedged more easily for duration risk and credit risk than liquidity risk. According to Federal Reserve data, the holdings of corporate and foreign bonds by the broker-dealer subsidiaries of domestic banks fell from over $400 billion in 2007 to $129 billion in 2013 and $83 billion at the end of Q1 2017.
The keys to liquidity: How big? When? Who? And What?
The size of the outstanding issue is of paramount importance. For a broker-dealer, the easiest way to sell a bond is to call a current holder and ask if they want to buy more. The bigger the issue, the more likely people are to be familiar with the bond. Recently, the largest holding of one large corporate bond ETF was an Anheuser-Busch Inbev issue that has $11 billion outstanding. The smallest reported holding of that ETF was an Enterprise Products issue that had $575 million outstanding. Issue sizes of $300 million are not uncommon in the U.S. corporate bond market.
AT&T? No problem. Methanex Corporation? That’s a problem. The greater the number of different bonds issued, and the greater amount outstanding in total, the more likely issues are to be liquid. One important point to keep in mind is that for certain small issuers that are household names (think Tesla and Under Armour), retail investors may be an important part of the holder base and that fact may affect liquidity depending on particular market circumstances. Selling a $10 million block may be problematic if there are few current institutional holders.
A 2026 maturity issued by AT&T a year ago? No problem. A 2026 maturity that was issued by Pacific Bell Telephone in 1993? That’s a problem. Bond Trader: “Can you scan the bond prospectus and send it to us via email? I’ll have one of my analysts look at it when they have a chance.” A 2015 FINRA study found that between 2003 and 2007, bonds issued in the last 90 days accounted for less than 20% of the most active 1,000 bonds. From 2011 to 2015, newly issued bonds accounted for about 45% of the most active 1,000 bonds. The same FINRA study found that after their first 90 days in the secondary market, trading volume fell by 38% in 2015.
A subordinate bond with a fixed coupon that goes to a floating rate coupon in 2021 but might get called instead, and the issuer can defer payments for ten periods. Bond Trader: “$70? We could probably pay $50 for that, but I’d have to find a buyer first. Do you have a copy of the prospectus? And the indenture, we’ll definitely need a copy of the indenture.” On a practical level, the more complicated a bond, the more cautious a broker-dealer will be in buying it for their own trading book. Vanilla, senior unsecured bonds are generally easier to trade than subordinate bonds. Secured bonds may even be less liquid than lower quality unsecured bonds from the same issuer because they have particular covenants that have to be carefully analyzed.
While the stretch for yield can create opportunities for increased income, a careful investor will balance duration risk, credit risk, and liquidity risk. Investor mandates often specify the duration risk and credit risk that their active fixed income managers take on their behalf. Managers are often left to manage liquidity risk on their own.
LM Capital specializes in active fixed income management using a top-down, macroeconomic approach supported by in-depth, bottom-up research in an effort to provide attractive risk-adjusted returns. One of the risks that we carefully manage is liquidity risk. We know that liquidity can disappear quickly and investors must be compensated for that risk. Carefully examining the liquidity of individual bonds is an important facet of the bottom-up portion of our investment process.
Statements by LM Capital are on its expectations, estimates, projections, and opinions and involve known and unknown risks, uncertainties, and other factors or are otherwise forward-looking statements. Actual events or results may differ materially from those reflected or contemplated in such statements. In addition, certain statements contained herein are from, or based on data from, sources or data presumed by LM Capital to be reliable, including Bloomberg, and LM Capital makes no representation or warranty, express or implied, with respect to their accuracy, timeliness, or completeness. Accordingly, LM Capital expressly disclaims any responsibility or liability for any loss or damage that may be incurred by any party who relies on the written materials contained herein.
Investing in securities, including fixed income securities, involves risks. You may lose some, a significant portion of, or all of your investment.
This information is provided for discussion purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any securities. It also does not constitute a solicitation for LM Capital’s investment advisory services.
LM Capital is registered with the SEC as an investment adviser. SEC registration does not imply any certain level of skill or training.