It is no secret that bond prices soared as stocks dived in late August. Refugees from stocks bought bonds when they could; but years of regulatory change, designed to shift capital risk away from banks left traditional dealers, such as the banks’ own capital markets units, with inadequate inventory. Welcome to the bond liquidity crisis, in which the trade a financial advisor wants to do is not necessarily the one that happens.
As stocks tumbled in the third and early in the fourth week of August, money rushed to safety. Government of Canada 10-year bond yields fell by 13 basis points (bps) to 1.33% by the end of the month. That was a big move, considering the modest return the bonds already offered.
Meanwhile, the spread between AA-rated corporate bond yields and federal bonds widened in the stampede to quality.
High market liquidity tends to mean small spreads, which implies efficient buying and selling. Impaired liquidity tends to mean large spreads and, sometimes, no trade at all.
Reduced inventories
The reason that bond trading isn’t as swift or even as profitable as it was a couple of decades ago has much to do with bank capital reforms, the focus of the Basel III banking reforms. Liquidity also reflects what many bond portfolio managers – especially of bond exchange-traded funds – have done to raise returns. These portfolio managers have moved to holding less liquid bonds, often smaller issues with wider bid/ask spreads.
The consequence for the bond market overall is that traders have a tougher time while buy-and-hold investors are little bothered. You could say this trend harkens back to bond basics – surely a sound thing.
Basel III rules increased the capital levels that banks must hold to back up their assets. Rather than commit large chunks of capital to bond inventories, which trade with very small spreads and profits, banks reduced shelf inventories. New regulations, including the Volcker Rule in the U.S. and Basel III, have required banks to raise capital to back the holdings of securities on their balance sheets, as Bloomberg noted in February, long before the August crisis. As a result, corporate bond inventories are one-third of what they were before the 2008 financial crisis.
For fund portfolio managers, there are fewer bonds to choose from. “Any issue or category of bond with a shadow of volatility or a rating under BBB is not likely to be kept at the bond desk,” says Benoît Poliquin, chief investment officer of Exponent Investment Management Inc., in Ottawa. “If the order has to be executed quickly, it won’t happen or you’ll have to accept a wider spread.”
A bond dealer may have to find a buyer or seller and act on an agency basis, as the dealer does for stocks, rather than (as bond dealers traditionally have done) as a principal dealing from its own account.
“Agency is a lot slower than trading out of inventory,” explains Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto.
The math of bond trading also works against speculative bond trading, as opposed to buy-and-hold investing. Ten years ago, the average corporate bond yield was about 5% and the bid/ask spread was about 2.5 bps. That combination worked out to 0.22% of a bond’s face value.
Soaring trade costs
Today, the trade breaks down with much lower yield and a much wider bid/ask spread. Lower coupon interest implies higher duration, so the trade cost has soared to 8.0 bps. As a proportion of the yield available, the cost of a trade has risen to 23% from 4%, states a memo from Citigroup Inc.’s credit strategy department. That means an investor has to hold a new bond for 85 days to earn enough yield to cover trading costs, vs the 15 days that was usual in 2005.
Global bond markets face the risk of what amounts to a trading illusion, Reuters reported this past June. The markets suggest that bonds are to be bought or sold as orders require. But that’s an illusion. Now, according to the Bank for International Settlements (BIS) in Basel, 20 portfolio managers account for 40% of all bond assets while dealers, such as the banks, reduce their inventories. The change shows that bond price risk has shifted from banks, as the BIS and Basel III intended, to investors.
More risk and tougher trading conditions mean that individual investors are pushed to the sidelines while investment funds take up the slack. The results vary. Fresh government and big corporate issues are readily tradeable. Existing government bonds are harder to trade and corporates harder still, says Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Ltd. in Toronto.
Lack of bids create a false sense of the market, notes James Hymas, president of Hymas Investment Management Inc., in Toronto, a fixed-income portfolio manager: “In a fearful environment, normal liquidity providers did not maintain the close spreads customary in the market and spreads widened.” Trades were less worthwhile, he adds, so there was a reinforcing effect -lack of bids thus caused further lack of bids.
These trends all point to declining bond market liquidity, a disincentive to hold harder-to-trade corporate bonds regardless of quality and, given the longer time required to cover trade costs in the high-duration market, lower returns in an already very low-return bond market.
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