In a bond market massacre, liquid products win

June 26, 2013

It comes as no surprise to those who understand markets that the less liquid a product is, the more its price will decline in a fast market rout. This has happened over the last few days in the municipal bond market.

The buying and selling of individual municipal bonds can be especially illiquid for retail investors because they don’t have much real-time market data. More importantly, they face very steep transaction costs, or markups, that dealers put on bonds sold in small lots. I wrote about this last week:

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8). SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent.

Although markups are a drag for most retail customers, there was an approximately 30 percent increase in customer buys on June 24. Customer buy orders climbed to 24,897, according to MSRB data, from the 30 day average of 17,699. Although the par amount of customer buy trades on June 24 was $5.2 billion – almost the same as the 30 day average. There were more, smaller, buy orders, and this generally reflects increased retail investor activity.

Although the number of customer sell trades was only slightly higher than the thirty-day average, we saw a big increase in the par amount traded. It grew from a 30 day average of $3.4 billion to $5.4 billion on June 24. This tells us that institutions were heavy sellers. We know this from the size of the bid lists that were circulating among dealers. These are lists of securities offered for sale.

Meanwhile, in the most liquid part of the municipal bond market, the iShares S&P National AMT – Free Municipal Bond Fund (aka MUB), closed up 1.45 percent on Tuesday. Its volume has gone from an average of 256,000 shares traded per day in the last 90 trading days to 964,000 shares traded on June 24.

More importantly, the liquidity of MUB allowed it to quickly restore losses it had suffered in June, when it lost 5.03 percent. In contrast, Thomson Reuters Municipal Market Data shows a massive sell-off for the same time period for the AAA GO bond 10-year benchmark. The yield increased to 2.81 percent on June 25 from 2.08 percent on June 3. This is a much bigger loss than the MUB suffered in the same period. There were simply not enough retail buyers in the traditional bond market to absorb the institutional selling (primarily mutual funds).

Is thin liquidity in muniland a systemic risk? I wrote about SEC commissioner Daniel Gallagher’s prescient “muni Armageddon” comments on April 24:

I interpreted Gallagher’s concerns to be related to the lack of liquidity in the market and the steep transaction costs that retail investors pay when they have to trade out of a position. Munilass may not know that Commissioner Gallagher, while previously serving at the SEC, went through a muni bond liquidity meltdown when the auction rate securities market collapsed in 2008.

This week’s market rout felt like 2008, when everyone is trying to rush through the door at the same time with few buyers ready to absorb the heavy selling (aka thin liquidity). Thin market liquidity leads to results like this:

The big dealers need to look past the current business model and find ways to make muniland more transparent to retail investors. As the capital that supports their trading books shrinks, they will find themselves increasingly in a position to execute on an agency basis. The SEC and MSRB must help enforce more pre-trade transparency and disclosure on markups. Muniland must be more liquid or we will suffer more market massacres.

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Interesting piece, and absolutely agreed – transparency for individual investors can’t come quickly enough.

It strikes me in reading that the problem of having retail investors trapped in smaller muni issuers could become significantly worse if the bond selloff continues. Retail managers competing on yield (and trying to avoid the interest-rate sensitivity of AAA paper) have been pulled into these less liquid parts of the market as well. If they need to sell any more of this paper, it’s likely that the dislocations will continue regardless of what info the individual investor has.

Interesting times.

Jason W

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