PMC Weekly Review - August 14, 2015
Bond market liquidity has long been a concern for investors, especially during market crises when it matters most. Since the most recent crisis in 2008-2009, however, the trading environment has changed dramatically in terms of its regulation, size, and structure. With the Federal Reserve (Fed) sending clear signals that monetary policy normalization is coming sooner rather than later, money managers have been working fervently to prepare for the new reality of fixed income markets.
The most commonly cited reason for the current situation in bond markets is a secondary effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act reform legislation in the United States. One portion of the law, designed to prevent excessive risk taking, brought about the decline of the so-called “proprietary trading desks”, run by investment banks and bond dealers to trade on their own account. These traders served, except in the most extreme circumstances, as the buyer of last resort and kept significant inventories of bonds on a daily basis. These inventories have since shrunk to a quarter of their pre-2008 size, as banks have de-risked and increased their Tier-1 Capital Ratios. The domestic bond market itself has changed over the last seven years as well. According to the Securities Industry and Financial Markets Association (SIFMA), the par value of fixed income securities outstanding grew 23% from 2008 to 2014, while assets in bond-focused mutual funds more than doubled to $3.3 trillion in the same period. The growth in bond mutual fund assets has many sources, but the largest of which is simple demographics. As the Baby Boomer generation has been approaching retirement (and the leading edge of this group is already of retirement age), pragmatic investing principles dictate a larger allocation to fixed income. As rates have continued to fall, some institutional investors have moved out of money market funds and into short-term bond funds to keep a minimum level of income. Finally, the Fed’s quantitative easing program has taken nearly $4 trillion in Treasury bonds and Agency MBS securities off the market, and it continues to be the largest buyer of new mortgage-back security (MBS) issuance, as principal and interest from the Fed’s balance sheet is reinvested.
Over the last seven years minus a few brief periods, the markets have faced lower liquidity driven by demand outstripping supply. However, it is our opinion that the real danger for investors and the markets as a whole is low-to-no liquidity driven by massive selling (supply) outstripping any demand. This is what we saw during the five- or six-week period in the second quarter of 2013 – the so called “taper tantrum”. In that case, the market corrected itself relatively quickly, but it put mutual fund managers on notice that this was going to be a problem again. The mutual fund firms have certain defensive measures they can use such as carrying higher levels of cash (a high opportunity cost), or using ETFs (which have their own expense ratios to pay ) to satisfy potential redemption waves, or putting credit lines in place to meet redemptions without selling current holdings at steep discounts. While these defensive measures can help protect investors in all but the most extreme situations, they fail to address the underlying liquidity issue. Beyond the explicit cost, relying on ETFs also fails to entirely alleviate liquidity concerns, as the underlying bonds held by these vehicles are subject to volatile price fluctuations in liquidity events. Several of the largest fixed income fund managers, as well as the Financial Industry Regulatory Authority (FINRA), have announced plans to develop electronic trading platforms in order to replace the outdated over-the-counter, call-your-broker system, but these efforts are still nascent and face the obstacle never faced by the equity markets in making the transition to electronic trading – the sheer differentiation and complexity that is inherent in the bond market. Agency trading, in which an intermediary connects buyers directly to sellers for a fee, may be particularly suited to allow institutional investors, such as pension funds, to provide liquidity to the market. Nothing will completely eliminate the risk of the bond markets seizing up as they did during the taper tantrum or the 2008 crisis, but prudent management can help reduce the impact of the next crisis on individual portfolios (at a cost). Ultimately, the domestic and global fixed income markets must find a way to share information on current demand, supply, and prices in a manner similar to the equity markets to develop an environment that can once again reach the liquidity levels of the pre-crisis markets.
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