Thursday, 20 September 2018

Who will buy my Austrian bonds?

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SwissInvest strategist Anthony Peters wonders how a bond can be too expensive to buy

Anthony Peters, SwissInvest Strategist

LOOK AT HOW investment grade credit is currently trading and you’d have to think we are in a raging bull market. New issuance is massively oversubscribed, spreads aren’t moving wider and it’s mightily hard to buy anything sensible in the secondary markets.

But there is a flip-side to this. As hard as it is to find paper to buy, so it is nearly impossible to find a bid for anything one might want to sell.

Either it’s (to the sound of the sucking of teeth) “a credit we’re not axed to buy” or, and this is new one, even on me, “they’re far too expensive for us to bid on and there are no buyers at that price either”.

I was brought up to believe that any security falls in price until it finds buyers and that it is the bid side which determines true value based on where dealers believe they can find placement. In other words, the laws of gravity apply to securities and “drifting higher” only exists in the world of financial journalism.

One of my mentors instilled in me the notion that there is a bid for everything – it might not be a bid you like, but there always is a bid.

No more.

Simon Ballard, a longstanding chum of mine and credit strategist at the National Australia Bank in London, put his finger on it when he wrote to me: “People are buying credit because everyone else is, because there’s nothing else to buy and because the central banks have effectively backstopped our bids. They are not buying risk because of a conviction about macro credit fundamentals. Such an investment strategy can’t be sustainable. In the absence of growth reappearing, any attempts to rally further will likely be quickly faded. Investors realise they are being hoodwinked.”

Central banks certainly haven’t helped market-driven price formation because their motivation for being involved in markets, call it QE, call it what you like, is yet again very different. Their objective has been to maintain an orderly market but in doing so, they have created an environment which is all but transparent.

THAT DOESN’T, THOUGH, entirely explain the disconnect between what investors seem to want to do and where bonds are priced in the Street.

Each bond used to have a life of its own. Its secondary price and liquidity were a function of its placement at issue, of the quality of the syndicate, of market-makers knowing where the paper was held.

Much of this has been lost through houses trading bonds to which they have no affinity (beyond the brokers’ quotes) and younger traders being brought up to believe the price of a bond is a function of the CDS quote combined with the price of other bonds for the same credit. The touch and feel has been lost and with it proper, price-determining liquidity has declined rather than increased.

What do you call a place where both are being turned away?

But please explain to me how a bond can be “too expensive for anyone to buy”? A diverse and liquid market is created when different people ascribe different values to an asset. This can be values based on a variety of interpretations of the same fundamental research but an asset can equally be of value because it fulfils a specific portfolio need such as resolving a liability matching situation.

So what, for crying out loud, is the purpose of forming a two-way price based on what some other asset is worth when the one in question trades neither on the bid side nor on the offered side of the quoted price? We can’t bid it because it’s too expensive but we can’t offer it either because we don’t own any. I thought a market is where buyers and sellers are supposed to meet. What do you call a place where both are being turned away?

PRICING SECURITIES ON matrix modelled relative value is pretty farcical. I have spent quite some time in the past week trying to sell some long-dated Austrian agency paper which – don’t ask me how or why – appears to trade through the relevant government bonds. Well, it would trade that way if it traded. For bonds to trade too rich due to technical events is fair enough but that cannot – or should not – be sustained.

Portfolio longs should be marked to the bid side of the market. In an ideal world, a portfolio ought to be able to be liquidated at – or very close to – its marked value. This, so far as I can tell, is not proving to be the case, and we might be looking at credit portfolio performance at the end of the last quarter which is plainly overstated.

In many cases, marked prices and market prices do not appear to be all that close  Now that investment grade credit investors are trying to shorten up and reduce holdings and risk as cash flows towards equities and high-yield, these chickens are coming home to roost.

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