I SUPPOSE IT must have been about six months or so ago that the issue of “liquidity mismatch” first came to broader attention. How could any fund – in particular any corporate bond fund – offer daily liquidity if the underlying assets were not liquid enough to be able to be traded in the market in size or at fair value?
Most of us market participants knew exactly what the issue was and what it felt like to ask for a bid in an issue in, say, US$10,000,000, only to be told that “I’m not axed to bid” or “I’ll bid for the US$1,263,000 which I’m short of and I will be happy to take an order on the rest”.
I’m not sure whether our frequent failure to find bids is because we are brokers but I have recently found that asking the odd hedge fund to front trades for me often results in better outcomes. A broker having to ask a client to front trades? What is the world coming to?
READING THE BUNDESBANK’S 2014 Financial Stability Report and its section on banks’ market-making activities in bond markets shows that central banks – or at the very least that one – are quite aware of the potential problems which the absence of consistent and reliable liquidity might bring.
I was there on that fateful day in February 1994 when the Fed reversed a year and a half’s worth of unchanged rates – very unusual in those days – and moved into tightening mode. Between February 4 and November 15, the FOMC tightened six times, taking rates from 3% to 5.50%. They then raised one more time in January 1995 to 6%, which marked the end of the cycle. The devastation which occurred in global bond markets was staggering as early incarnations of leveraged rates products, normally wrapped in a corporate MTN, blew up in people’s faces.
Not long before, Alan Greenspan, then Fed Chairman, had warned markets that the period of stable and low interest rates was coming to an end and in a speech he clearly declared that only idiots would not be preparing themselves for the tightening. I cannot tell you how many idiots there subsequently proved to have been out there. Bond markets – we didn’t distinguish between rates and credit back then – a bond was a bond – went into free-fall and it was then that I was taught that being long is better than being short. You couldn’t always get an offer but you could always get a bid. You might not have liked the bid, but at least there was one.
Since then, though, the world has changed. The Bundesbank acknowledges in its report that some bonds still trade well on two-way markets. That is true, albeit that the universe of liquid bonds has shrunk to such an extent that eurozone authorities are now making noises about no longer treating all member states’ government issuance, credit ratings aside, as equal in terms of risk. Bonds of the largest corporate names and the senior paper of the major banks looks all right, but the past few years have brought a plethora of issuers to market, the bonds of which don’t stand a snowball in hell’s chance of ever trading normally, even under the most modestly stressed market conditions.
I WAS LUNCHING with a senior market observer this week – I think he’s one of the smartest guys on the planet – when the issue of market liquidity came up of. We wondered what would happen if a significant investor called a bank with a long bid list of, say, €1,000,000,000? The consensus was that the trader would be tempted to bid for €20,000,000 as a relationship trade and then run for cover. This sort of response would sooner or later push investors back into the practice of simultaneously calling as many houses as possible and spraying paper all over the Street before dealers could grasp what was going on and prices gapped down. Dinosaurs like me will remember what happened the morning after the Piper Alpha platform went down in the North Sea in 1988 with all hands on deck. If my memory serves me right, it was AON who owned the risk and whose portfolio management team cashed out first thing. They had hit every bid in town before anyone had worked out that being called for an early trade was not the sign of a great relationship, but of being caught napping. There were a lot of calls going around the Street that morning – we still had head-to-head markets – which ended with “Oh, you too?”
But if the Street can’t behave properly, how can investors be expected to?
More to the point, if those many control and compliance specialists who now populate banks and asset managers alike – the ones who know exactly how to trade an illiquid market in a panic – insist on trades only being executed in the context of multiple and visually verifiable prices, many investors might find themselves persistently behind the curve as prices gap down and gap down again. Consensus remains that the first one to hit the bid will be fine, but that thereafter selling bonds will be a random walk. Many of my US contacts are already cursing the Trace reporting system for creating a false sense of transparency and liquidity that might excite compliance officers but which does little to help markets work efficiently.
Investor protection could one day easily find itself turning into investor destruction – and I’m not thinking of the asset management firms, I’m thinking of their own paying customers such as you, me and Bobby McGee. Meanwhile, the various business prevention departments will be able to claim that they were only obeying orders.
I DON’T KNOW how many first-time issuers, both investment-grade and high yield, are showing up in the corporate bond market every year, but without meaningful credit curves, no CDS to give generic pricing and probably with a limited universe of banks trading the names, the risks of gapping prices increases significantly.
As of now, the spread premiums which such putatively illiquid bond issues should be carrying are not there. These lurking mark-to-market hits are stored up somewhere, ready to strike when markets are tricky and the last thing money managers will need is bond prices which look to have been plucked out of the sky. As Greenspan said back then, the warning signs are clear for all to see and only idiots will not be prepared.
