As trading activity declines, new routes to liquidity emerge

September 12, 2012

Municipal bond trading volumes are on a downward march. The Municipal Securities Rulemaking Board (MSRB), which oversees muniland, publishes trade statistics on its website. You can see on the chart below, which shows daily trade volumes, how “customer bought” trades especially have been trending down. These are trades done by retail and institutional clients to acquire bonds.

“Customer sold” trades, which generally represent funds or brokers selling bonds out of client accounts to be replaced with other bonds, have been relatively steady. Bonds are sold to raise cash and to move assets to other classes. Interdealer trades are done between dealers to transfer bonds that are sold onto clients who are not dealers (think retail and institutional investors).

There are several reasons for declining trade volumes, but foremost is the very low level of yields on municipal bonds today. Taylor Riggs of the Bond Buyer, who reports dealer trading desk activity, tweeted this on Tuesday:

With very low yields there is not much “spread” — the difference between the bid and offer price — for dealers to capture. The market effectively becomes more sluggish because there is less incentive for brokers and dealers to search out trades. Investors would usually prefer to wait on the sidelines for higher yields before getting back in the market.

There are structural reasons for lower volumes too. Trading tends to be concentrated in recently-issued and larger issue bonds. The BlackRock Investment Institute recently published a report, “Got Liquidity”, that discusses the evolution of bond trading in the last ten years. The report highlights (page 6) how trading liquidity tends to be in the biggest bond issues. In muniland the multi-billion dollar bond issues tend to come from California, Texas and Illinois and other state issuers. From “Got Liquidity”:

The liquidity is bunched up in large new issues. Only issues of more than $1 billion and those less than a year old recorded volume growth in 2011, according to MarketAxess. Liquidity of older and smaller bonds dropped across the board.

Trading is easiest for the largest market participants, (think mutual funds, pension funds, hedge funds and property insurers) and they tend to have the best access to new bonds when they are underwritten.

Another factor in lower trading volumes is that overall municipal bond issuance declined rapidly after the financial crisis. Also, as interest rates have declined, much of the latest issuance – about 60% in 2012 — has been to refund older, higher interest-rate bonds. When old bonds are refunded before their maturity dates, the cash is returned to bondholders who often turn around and reinvest in the newly issued bonds that replace the refunded bonds. The circular reinvestment effect of refunded bonds tends to increase overall demand for bonds.

When interest rates and bond yields increase it’s likely that we will also see increased municipal bond trading volumes. If and how trading patterns will change is hard to predict.

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