When bonds don’t trade

By Felix Salmon
November 5, 2013

In the September issue of Euromoney, Peter Lee has a huge investigation into what he calls “the great bond liquidity drought”. The landing page for the story features subscriber-only links to the whole thing, as well as free-to-access links to various sections. But it also neatly summarizes the problem a single paragraph:

Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt. New regulations on the leverage ratio that will reduce banks’ repo funding books threaten to make matters even worse and to spread the drought from credit markets to rates, the underpinning of all financial markets. Secondary markets are close to a breakdown that will soon imperil the primary markets on which companies and sovereigns depend for funding. All that is masking the decay is the extraordinary actions of central banks.

Here’s a chart from Citigroup which helps show at least part of the story:

Loss of Shock Absorbing Capacity.jpg

This chart doesn’t just cover Citigroup, it covers all bond broker-dealers. They massively increased their inventory of bonds during the 2000s bubble — but so did everybody else: total credit assets were raising substantially over that period. Then, after the financial crisis, came the great divergence. Broker-dealers retreated from the market, even as investors continued to seek the safety of bonds. So while broker-dealers were about half the size of the credit mutual fund industry in 2007, according to the quantity of assets they owned, today they’re only about 1/20th of the size. And those broker-dealers are still the only real liquidity providers in the market. If you want to buy or sell a bond on the secondary market, there’s really only one way to do it: phone a bunch of broker-dealers, ask them to make you a market, and either accept the best price you find, or don’t.

Lee’s article makes a very strong case that the only way out of this problem is for buy-side institutions to start trading directly with each other, since the broker-dealers have enough to be able to provide good service only to their very best clients. But neither of the two buy-side bond market giants (Blackrock and Pimco) seem to have been able to make such a system work, and although the MarketAxess system is growing fast, there isn’t going to be any fundamental change unless and until bond investors start making buy/sell markets of their own. Which is simply not going to happen: bond investors don’t tend to think in terms of opportunistic trading, precisely because their portfolios are so illiquid. What’s more, the ability to make a two-way market is contingent on the ability to buy one name when you sell another, which is not something anybody can reliably count on being able to do any more.

In other words, we’re living through a vicious cycle: the less liquid the market gets, the less ability there is for anybody to make markets, which in turn just worsens the liquidity problem. And things are only going to get worse still if and when QE goes away.

The implications, as Lee says, are enormous. The whole point of bonds is that they’re tradable: you don’t need to hold them to maturity. But increasingly you do need to hold them to maturity, since finding a buyer for your inventory is extremely difficult — especially if you’re investing in size. This is one reason why the two big bond investors arguably pose a systemic risk: if either one of them were to suffer substantial withdrawals, the selling pressure on the market would be so enormous that the entire bond market could pretty much cease to work. It’s already extremely difficult for bond funds to grow without changing their risk profile: while it’s possible to buy large positions in the primary market, it’s basically impossible to continue to add to those positions as your fund increases in size.

Part of the problem is the degree to which the market is fragmented: GE has more than 1,000 separate bond issues, while Citigroup has almost 2,000. (Both of them, of course, have only one equity security outstanding.) But there’s little incentive for companies to issuer fewer separate bonds, since the primary market is the one place where the bond market actually seems to work. And besides, if the bond market becomes harder to navigate, companies always have the option of going to the loan market instead, or raising equity instead of debt.

For sovereigns, however, the fate of the bond market is of paramount importance: they have to be able to issue debt, even as major banks are withdrawing from the markets entirely. And sovereign bonds are being hit just as badly as corporate bonds by the liquidity drought:

Traders say that without moving the price the markets might still absorb a large customer order for €250 million in German Bunds, maybe €100 million in French government bonds, perhaps €50 million in Italy and €25 million in Spain.

In Portugal, which has no direct market access of its own, Lee adds, it’s almost impossible to buy a position of any size at all without moving the market, with even the benchmark 10-year bond gapping out as much as 100 basis points on minimal underlying volume.

The result is that the bond market is going to have to contend with more than just rising rates over the next few years: it’s going to have to deal with rising illiquidity premiums as well. A bond yield will be the benchmark rate, plus the credit spread, plus the illiquidity premium, and it’s going to become impossible to disentangle the last two variables, especially when benchmark government bonds themselves are often quite illiquid. The effect on aggregate global borrowing costs could add up to trillions of dollars, and severely crimp the ability of the bond markets to finance growth.

Still, over time, those extra trillions of dollars are going to find their way into the pockets of bond investors: an illiquidity premium is still a premium. It’s never nice to see rates rise, but once they’ve risen, the extra yield will surely be very welcome to savers. And for the time being, at least, borrowing costs are not really a problem for most issuers with market access. If companies have to pay an extra 50bp to borrow money, so be it — they’ll live.

Sovereigns, however, are another story — they need to borrow in size, and they have historically relied on liquidity issues to ensure that they get the cheapest possible rate. (That’s the main reason why US Treasury bonds have the lowest yields in the world, on a swapped-into-dollars basis: it’s all about the liquidity, not the credit risk.) The great bond liquidity drought is arriving at the worst possible moment for G20 sovereigns which are already struggling with unprecedented levels of bonded debt. It’s always liquidity that kills you, not insolvency: it’s the inability to roll over your debts as they come due. Which means that the next wave of sovereign debt defaults might come even sooner than many analysts currently fear.


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Why do bond holders need to trade directly? Look at the equity markets. Dealers don’t provide much inventory and capital support there, but they do play a facilitation role, and the exchanges and ECNs enable transparent price info among market participants in real time.

Trading direct makes no sense. The mouse traps and templates are already in place for the next gen of bond trading. Just need the regulators to figure this out.

Posted by TXC | Report as abusive

Hi Felix. I am with you until the last paragraph. The last para mixes up liquidity in the primary market with liquidity in the secondary market. The rest of the piece is all about liquidity in the secondary market and you provide ample evidence that there is a problem. But the last para then links this to a possible lack of liquidity in the primary market as it is in the primary market where the sovereigns rollover their debt. There is no evidence of a lack of liquidity in the primary market so I don’t think your analysis in the last para is sound.

Posted by Gennitydo | Report as abusive

Yes dealer inventory is down. Yes the big wirehouse investment banks have pulled back. Look at Pimco Total returns turnover ratio though… it’s over 300% annualized. I think they are basically prop trading bonds for the benefit of their investors. I’d bet dollars to donuts they have bought and sold a million dollars of the same bond on the same day.

Posted by y2kurtus | Report as abusive

“Market Making” = code for ‘front running’.

Posted by Ed62 | Report as abusive

I don’t agree with this sentence:

The whole point of bonds is that they’re tradable: you don’t need to hold them to maturity.

In the “good old days” bonds were largely bought by long term investors to match long term maturity obligations, and only traded occasionally when someone wanted to sell and then a broker could work out a swap (probably with a nice spread).

There were bonds with active markets, but they were a small segment of the total outstanding issues.

I think the real looming crisis here is the rise of bond ETFs, which claim to be seriously liquid, but are not in reality. Used to be (and I think still is) that mutual funds had an option to delay redemption for up to 30 days (as I remember). They would hate to actually use it, but they could to avoid disaster.

Now, with actively traded ETFs (see Bogle on how actively) we have created something that will come to a screeching disaster once rates start up and people try to bail out in a hurry. A bond ETF (except possibly money market funds) seems to me to be a dangerous and a dumb idea if people buy them thinking of them as “liquid” and actively tradable.

Posted by RexD | Report as abusive

That is not true. Buy publicaly traded bonds and you have liquidity with almost all brokers.

Posted by LeRoyKYoung | Report as abusive

Through the lens of the maker/taker lens it does indeed look like liquidity is in rapid decline. This is however a structural issue that has been exacerbated by regulation. As a result the sell-side has modified it’s business model from warehousing into facilitating, especially for larger orders.
What has not changed is the trading infrastructure. Here the buy-side are still required to approach the sell-side for liquidity where the illiquidity premium applied to the trade by the sell-side means a larger trade simply cannot match the transaction cost expectation for the buy-side.
One way of mitigating the transaction cost is to match buyers with sellers who can then trade around the mid, whether it is buy-side to sell-side or buy-side to buy-side.
The present RFQ or CLOB models discourage anyone from disclosing their way in larger size due to market risk.
The new infrastructure needs to accommodate market risk by enabling all to all matching, negotiation and trading. This does not mean excluding the sell-side as they remain critical to price formation in return for which they facilitate risk-free crosses between the buy-side.
There is abundant liquidity in the market, but under present circumstances it is very risky to expose it and discover the other side.

Posted by Bondcube. | Report as abusive

“If you want to buy or sell a bond on the secondary market, there’s really only one way to do it: phone a bunch of broker-dealers, ask them to make you a market, and either accept the best price you find, or don’t.”

Wow, that’s sounds just like NASDAQ back in the day. Of course, back then, it’s motto was “My word is my bond.”, so there’s no way that would fly nowadays. Somehow, it was possible to buy and sell stocks that weren’t listed on a major exchange despite the requisite heavy lifting. An awful lot of options trading works this way even today. If you want to trade something bespoke, you call a market maker and ask for a price and they call you back with the numbers. If using a phone is so onerous these days – I’ll admit that cell phone sound quality is so bad that OSHA should step in – perhaps Twitter can fill the niche and maybe have a business model.

Posted by Kaleberg | Report as abusive

What happened to the old days? There was a New York Bond Ticker that displayed bond trades on the NYSE. Amex bond trades appeared on the Amex ticker. S&P published a book with all the bond’s characteristics and their symbols. The previous day’s trades were displayed in the New York Times with prices and yields and whether they were trading flat or not. You could get a quote for a bond on the Quotron that your broker would honor. In short, what is wrong with trading bonds on an exchange?

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