On Bond Market Illiquidity (and more)

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On Bond Market Illiquidity (and more)

What’s more Illiquid than the desert?

I’ve read a lot of articles about bond market illiquidity, and I don’t think it is as big of an issue as many are making it out to be. The bond market often runs hot and cold, and when prices and yields are moving, it is difficult to get off trades at levels you might like unless you are resisting the trend. And if you are resisting the trend, will you like the trade one week later, when the trade might look poor in hindsight?

Part of the difficulty is that the buy side has gotten more concentrated. Bigger players by their nature can’t move in and out of positions without moving the market against their interests. Illiquidity is a rule of life for them. They may as well become market makers to some degree — offering bonds they want to keep at prices at which only the desperate would want to buy. Also, they could bid for bonds at levels at which only the desperate would want to sell.

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Add into that the amount of bonds tucked away in ETFs. The ETFs may seem to offer liquidity at no cost, but retail investors tend to panic more rapidly than institutional investors. If retail investors run away from any part of the market, the ETFs in that part of the market will be among the managers selling into a falling market, and there is a cost to that, at least for those slower to sell the ETFs in question.

But away from that, current monetary policy leaves many on pins and needles waiting for short rates to rise. Now, there is no guarantee that short rates will rise in 2015. The Fed has shown itself to be extra slow to act in this cycle, and the current FOMC has no hawks — not that the hawks matter — their views are not a part of current monetary policy.

But even if short rates rise, there is no guarantee that long rates will follow. In the last tightening cycle, long rates stayed the same with a lot of noise that included falling long yields in the early phases. The global economy isn’t that strong, and interest rates in the middle of the curve tend to track nominal GDP growth (with a lot of noise).

You can position yourself for rising short rates, but you have to give up a lot of income (carry) to do so. How long can you bear to earn very little, particularly if you are earning a management fee that eats up a lot of the income?

Situations like this are naturally twitchy, because things are unclear, but as things clarify, there may be many who will want to sell longer bonds to buy shorter bonds where rates will rise. If long rates do rise along with short rates, who pray tell will be the philanthropist that holds onto the long bonds and eats losses for clients that want positive (or at least small negative) total returns?

There is a price for almost every asset, but there is no guarantee of being able to sell a lot of long bonds if rates are rising, and certainly not without offering a large price concession. That’s illiquidity, which naturally happens if you try to trade against a large trend in the bond market.

That brings me to my main point:

Bond market should be illiquid now. Why should you expect otherwise?

No one is out to do you voluntary favors in the markets. Why should markets have narrow bid-ask spreads when there is significant policy uncertainty, and large players that hold a large fraction of the total bond market? At a time like this, I would only want to make a market if the compensation was significant.

Two unrelated notes before I sign off. First, I sold my position in long Treasuries about a month ago, when 30-year yields crossed 2.80%. I had owned the long bonds for quite a while and had decent profits on them. I felt the current selloff might have legs, which may be true (or not). So, I am below market duration at present, and earning ~4% off of a variety of short investment grade corporates, bank loans, junk bonds, TIPS, and foreign bonds… so far so good, but I can’t express any significant confidence that this strategy will be a winner. It’s my best guess for now, as I don’t see many immediate credit risks. After all, look how little damage the energy sector took on even with oil prices that fell hard. There is a lot of money looking around for bargains.

Second, if I were a large corporate bond issuer, I would look to form a consortium with my fellow large issuers to set up an auction market for the new issuance of bonds, and bypass Wall Street. Why? Because the new issue yield premiums are large. Why should large money managers benefit from the new issue market? Yes, I know that offering liquidity should receive some reward, but not as large as it is at present.

This is a modern era, and the need for intermediaries in the IPO market for bonds is less needed. Let the buy side, which is starved for new bonds and yield, pay up for the privilege of receiving the bonds. Who knows? Maybe the issuers might borrow a little more as a result.

Hey, CFOs of large bond issuers! This is your chance to become a hero. Grab the opportunity, and issue your bonds with your peers through a mutually owned central action house. Who knows? One day you could spin it off, and it could become… an investment bank.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.