As regulatory burdens have pared back the appetites of large banks and primary bond dealers in the “off-the-run” US Treasury market, bond liquidity has suffered and transaction costs, most notable in wider bid-ask spreads, have increased. Institutional investors in the $14 trillion government debt market are looking for alternatives, Greenwich Associates Kevin McPartland notes in a recent report.
As adjustments to Dodd-Frank regulations get considered in Washington DC, charges that the negative impact from the Volcker Rule has resulted in less market liquidity swirl. A recent Bank of America Merrill Lynch report, for instance, predicted that the corporate bond market “could get ugly” if interest rates rise quickly.
“Counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels,” the report pointed out, to some degree reflecting issues seen in the off-the-run Treasury market. Bid-ask spreads in both markets have been on the rise and bond liquidity has been falling.
In the US Treasury market, Bid / Ask spreads are by far considered the largest components of transaction costs, according to 53% of bond dealers, asset managers and central banks taking part in the Greenwich study. Since 2008, the bid / ask spread has gotten wider, according to 65% of those surveyed, while only 9% say spreads have tightened.
When compared on-the-run liquidity, a majority of which is transacted electronically, off-the-run transactions, often involving humans, sees a 40% transaction cost increase and an overall 16% price increase. It also takes nearly 1/3 longer to execute the often more complex bonds that contain different maturities and other non-standardized features.
Most market participants have seen bond liquidity decline since the 2008 global financial crisis, with 91% of survey participants of firms with $100 million to $500 million in average daily volume, are seeing the most differential.
McPartland notes larger players “continue to receive preferred pricing and access to balance sheet when it's needed” while smaller players “received second-tier pricing since before the crisis and, thus, have not seen a measurable change.”
A component of the bond liquidity issue is seen in partial order fills, as nearly half the survey participants observed they were less likely to complete orders today than they were ten years ago.
“The cost of holding those positions due to new capital rules—and the risk of regulators viewing the position and ultimate sale as proprietary trading banned via Volcker Rule—has reduced dealers’ willingness to take that risk and, in doing so, hurt liquidity for investors,” McPartland explained. “Market participants must increasingly accept current market conditions as the new normal and adapt their trading and investing practices as needed to ensure they can find the liquidity they need at a price they are willing to pay.”
This high cost of doing business could change, but don’t count on it.
While the rhetoric of political change out of Washington DC have been signaling an ease in capital requirements on banks along with a general easing of financial regulations, McPartland tells his readers they the “should not hold out hope that those changes will come through in the short term—if ever.”
We are living in the new normal of bond liquidity, he says. However, a ray of hope is available as the “market is warming to new ways of trading, as it becomes clear the old way is unlikely to ever return.”
The glory days of humans buying and selling from humans is a quaint notion of the past and both the buy and sell side should adjust accordingly.