There can be unexpected fire sales of bonds when other asset categories go into free fall. Perfectly sound corporate and government bonds tumble in price as investors, desperate to pay margin accounts or reduce other kinds of leverage, sell at whatever price they can get. By being alert to bargains during such liquidity crises, you can boost your clients’ bond returns.
Bonds plummeted during the 2008-09 stock market collapse. As stocks tumbled between June 2008 and March 2009, the DEX universe bond index, which is composed of 60% Canadian government bonds and 40% corporate bonds, plummeted along with stocks. The bond loss was 4%, compared with the almost 50% stock index loss at the nadir of the crisis, but the principle is clear: during a liquidity crisis, everything goes on sale.
The reasons that bonds do not instantly take up what the stock market gives up lie in the way dealers make markets. Dealers, mainly the brokerage units of chartered banks, observe that markets are falling and, therefore, widen their buy/sell spreads. The dealers increase margins so that they do not get caught paying too much before they can sell. They rush to dispose of inventory, says Heather Mason-Wood, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont.: “The dealers’ moves are their way of cutting their risk.”
In effect, the dealers build in wider spreads as a buffer. The risk that any one dealer will do fewer trades is offset by the knowledge that other dealers are doing the same thing. The action of widening spreads makes the markets less liquid, so the perception that markets will lose liquidity becomes a self-fulfilling prophecy.
Still, not every stock or commodity market crisis chokes liquidity in other markets. The 1997 Thai baht crisis and the ensuing meltdown of Southeast Asian equities markets did not dry up liquidity in North American markets, as Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax, points out. But that event was 15 years ago and long before high-frequency trading and overnight platforms compressed the distance and time separating global markets.
Today, it is reasonable to expect that a major crisis in one market will echo in others. Given that bonds trade over the counter and that dealers are principals filling orders from their own inventory, their self-protective tactics are understandable.
Call it a “liquidity gap.” The problem, which can be severe in the stock market, is exacerbated in bonds. The bond market is almost entirely over the counter — the exception being direct sales of new government bonds by the Bank of Canada or the U.S. Treasury at time of issue. Circuit breakers that have been built into stock trading do not exist for bonds that trade over the counter. In times of financial terror, dealers won’t buy bonds if they cannot be sure of an immediate sale — and many buyers retreat.
Bonds go to deep discounts during liquidity crises. The first sign of dealers’ widening spreads comes when on-the-run (actively traded) government bonds, especially U.S. Treasury issues, start to trade at appreciably tighter spreads than off-the-run (lightly traded) issues of treasuries with similar maturity dates, says Chris Kresic, co-lead for fixed-income and partner with Jarislowsky Fraser Ltd. in Toronto.
“On-the-run bonds get to be very rich in comparison to off-the-run bonds as buyers swap into the most liquid bonds,” he explains. In other words, inves-tors pick up on-the-run issues for liquidity and willingly pay for it.
During the financial crisis of 2008-09 and during moments of bad news and ominous prospects for Europe’s many crises, U.S. treasuries were being purchased at prices above redemption value, which guaranteed negative yields. That’s risk aversion pushed to the point at which investors are paying insurance premiums for liquidity.
“You look for the least liquid bonds with the best credit quality,” Kresic says. “You can then harvest the difference in prices. We do it. And, for the small investor, periods of illiquidity are good opportunities.”
A buy-and-hold trade for an off-the-run, investment-grade corporate bond, often with a 20-basis-point (bps) pickup in yield and with a potential 100-bps yield boost during deep crises is an opportunity that should not be disregarded. After all, in a market in which 10-year government bonds pay 1.8%, that gain for a buy-and-hold investor is a gift, says Timothy Hicks, vice president with Canso: “A lot of institutions don’t buy off-the-run bonds because their back offices can’t deal with them.”
That’s because such bonds may have odd features, such as amortization (preset or variable return of capital before maturity), that make them different from ordinary corporate bonds, which return principal at maturity. Off-the-run bonds, therefore, are harder to sell to other institutions, which adds to their illiquidity. In a crisis, these odd bonds may be dumped in favour of other bonds that are easier to value. “For the patient investor,” Hicks says, “buying in a liquidity crisis can add to profit without adding fundamental risk.”
The illiquidity premium lasts until the buyer wants to sell his less liquid bond, when he or she may have to give back what he or she has gained, Hicks warns. Call this a buy-side tactic. Selling the bond with a wide spread may take away what was gained on the way in.
Illiquidity is best used as a buying opportunity: holding the bond until maturity eliminates the discount. IE