A recent research report from Royal Bank fo Scotland makes grim reading. “The credit liquidity trap” points out that a European corporate bond issue now trades on average once a day by volume versus nearly five times a day just over a decade ago. It is no better in the US, where corporate bond trading volumes relative to the size of the market have been on a steady downward trend since 2005 and the US Securities and Exchange Commission shows that nearly 20% of corporate bonds do not trade at all.
Corroborating the gloom of recent research notes, Jan Dehn, head of research at investment manager Ashmore, estimates that liquidity is down around 70% since the collapse in 2008–09. He is not entirely sympathetic.
“It is entirely self-inflicted,” said Dehn, explaining that governments had undertaken regulatory changes and pursued banks as culprits. He called it a need “to satisfy the calls for blood lust”, but all this has done is “restrict banks’ abilities to take risks”.
The finger of blame must be pointed in particular at Basel III regulations. These have significantly increased the capital that banks must hold against almost all assets, but against emerging market bonds and corporate bonds in particular. Restrictions on proprietary trading by commercial banks instigated by the Volcker Rule have in all likelihood had an impact on the inventories of US banks too, but there are still some pockets of liquidity.
“We are seeing liquidity in certain sectors – there is liquidity for Tier 1 and contingent convertible bond issuance, for example, thanks to hedge fund participation. We do see turnover there,” said Edward Stevenson, head of FIG debt capital markets origination at BNP Paribas.
But these are the exceptions rather than the rule.
“The regulations have biased the banks against trading anything other than government bonds. Debt with a higher regulatory cost is simply not being traded,” said Ashmore’s Dehn.
Perhaps paradoxically, restrictions have happened at the same time that demand has increased, which has made the liquidity problem worse.
“New capital regulations have come into force while the credit market has grown significantly over the last few years, with more new issuers and issues – increasing de facto the fragmentation of the credit world. All of this combined makes the liquidity even more challenging,” said Olivier Gazzolo, global head of credit at Societe Generale.
With more investors chasing fewer issues, moans about the allocation process have become louder. One European syndicate head explains the dynamic of current deals. With a €500m trade it is not uncommon to see up to 600 investors fighting for allocations. The very best that one account could hope for would be €40m–€50m. Complaints about favouritism are perhaps inevitable, though unfair.
“We have to be more transparent with allocations. Syndicate teams are just not in a position to favour their nearest and dearest,” said BNP Paribas’s Stevenson.
A further effect of the new dynamic is that all of the action is in the primary market, with comparatively little happening in secondary trading.
“Investors are going long into primary and sitting on it,” said SG’s Gazzolo, pointing that there is simply not the same incentive to turn over the book as there used to be.
The figures here too are stark. Corporate bond credit trading volumes might have remained stable in absolute terms at around US$20bn a day in the US for the last five years, according to figures from RBS. But while that might not have moved, the corporate bond market itself has grown by around 60% since 2007 to about US$9.8trn. As the bank points out, this means that daily volumes have gradually declined to around 0.2% relative to the size of the market.
With buy-and-hold increasingly a necessity rather than a choice, investors might have expected some compensation for this lack of liquidity. But the premium for liquidity risk is close to pre-crisis lows across all fixed income markets.
“There is a concern that we, as investors, have not being compensated for lack of liquidity. There has been a drive-down in yield and a drive-down in premia,” said David Riley, head of credit strategy at BlueBay Asset Management in London.
To put this into perspective, for most of the year bid-ask spreads on the five-year CDS of iTraxx and CDX index have been close to post-crisis lows. Electronic trading platform MarketAxess reckons that corporate bond bid-ask spreads in both US and European credits have fallen from more than 40bp in 2008 to less than 6bp. It estimates that European and sterling spreads have dropped by 25% in the past 18 months alone.
Private placement growth
A side-effect of the lack of liquidity in the public bond markets has been the growth of the private placement market. Although figures are notoriously hard to come by, anecdotal evidence suggests that investors are beginning to focus on private placements and block trades.
“A few years ago, it was almost impossible to sell a five-year vanilla €100m private placement. Now, investors can’t get enough of them,” said Eric Cherpion, global head of DCM bond syndicate for Societe Generale. He points out that there has been an increase in vanilla corporate private placements and mid-cap transactions sold to a single investor or to a club.
A significant sign of the demand is that the cost of issuing in that market has come down. It used to be that issuers would have to pay a premium of 10bp–15bp. At the moment, say DCM desks, there is no premium, or even a slight discount.
Much of the attention on the lack of liquidity in the bond market is now focused on investors. In a report earlier this year, the IMF warned of the risk for investors in the bond markets, especially mutual funds and ETFs. It raised concerns about a potential asset-liability mismatch. These were based on the thought that US retail investors, who have pumped more than US$1trn into bond funds over the past five years, might decide to withdraw their cash en masse. Although investors can withdraw their money on demand, fund assets can be hard to sell in a crisis.
At the end of the first half of the year, the US Federal Reserve debated whether it made sense for regulators to impose exit fees of some kind on bond funds. The fear-phrase of the moment about such funds became “shadow banks”. This was based on the frequently cited observation of Jeremy Stein, former governor of the Fed, that “bond markets are the new banks”.
The unpopular, though understandable, threat of fees appears to have been no more than that. BlueBay Asset Management’s Riley suggests that the threat had receded given the way that the market had behaved during the summer’s high-yield sell-off.
Record withdrawals from US high-yield bond funds pushed average yields to a six-month high of 6.3% at the beginning of August, according to Bank of America Merrill Lynch index. Estimates are that ETFs saw US$3.7bn of redemptions between the end of June and early August.
“The sell-off was driven by retail investors and ETFs. Passive funds have to be cash sellers and when the underlying market is struggling to meet that demand it could exacerbate a rush to exit,” said Riley. But that is not what happened.
“Many did fear retail outflows to be on a par with the taper tantrum, but price action has been orderly. Part of the reason for that is that institutional buyers have put cash to work to buy bonds at an attractive price and duration against the backdrop of still strong corporate credit fundamentals,” he said.
One crisis averted, but that does not address the fundamental problem of a lack of market liquidity. If anything, the legislation and the enthusiasm for Basel III has made matters worse. The threat has moved from the corporate bond market to the government bond market.
“The potential for a liquidity shock in the US Treasury market has increased,” said Ashmore’s Dehn.He points out that the share of US Treasuries held by the Fed and a number of foreign central banks increased from US$1.1trn in 2009 to US$6.4trn at the end of the first quarter this year.
Forget worries of retail investors wanting to unwind their holdings, this concentration in a small number of hands does not bode well if there were a sell-off of US Treasuries.
“If that were to unwind, it would not go gently into that good night,” said Dehn, quoting Dylan Thomas.
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