Inevitablility: Examining the Cause of the Illiquid Bond Market

The Fed, Congress philosophically opposed

by Timothy Bernstein, Analyst, NewOak

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As we move into the second week in June, a month during which a rate increase by the Federal Reserve is looking less and less likely, it is nevertheless worthwhile to revisit the illiquidity issue in the bond market and its roots in contradictory monetary and f iscal policy.

For some time , the corporate bond market has been characterized by its perceived lack of liquidity — a complex concept defined here as the ability to buy or sell a security without significantly affecting its price.

This perception is accurate, to a degree: trading volume for investment – grade corporate bonds has declined 50 percent post – crisis, according to a Deutsche Bank analysis, while volume for high – yield corporate bonds has fallen 30 percent in the same time frame .1

From Stability to Volatility

However, it is in the market for U.S. Treasuries, typically the most liquid of bond markets, that we can see the most pronounced trend of declining liquidity, as post – crisis trading has fallen a massive 70 percent.2 Subsequently, these same markets have seen rises in price volatility, as fewer available bonds make it difficult for investors to buy or sell at the price they want. Price swings for Treasuries, which hit a low in 2013, are up 75 percent since then.3  

At the heart of this decrease are measures taken by the Federal Reserve and Congress that lie in philosophical opposition to each other. Following the financial crisis, the Fed attempted to jumpstart the economy with a combination of quantitative easing (QE), which inclu ded massive purchases of Treasury securities, and low interest rates.

Ironically, these measures were taken to increase a certain type of liquidity — making the financial system newly flush with cash to borrow at low costs, which would then spur somewhat ris kier investments and get the gears of the U.S. economy turning again.

However, by taking such large chunks out of certain bond markets, the Fed’s QE program actually left those markets vulnerable to increased volatility, barring any sudden influx of new is suances by private issuers.

The Regulatory Domino Effect

The increasingly stringent regulations put in place by Congress and other major market regulatory regimes made the sudden influx of new issues impossibility.

Historically, large financial institution s served as the “market makers” for fixed – income securities, holding large amounts of corporate and Treasury bonds so there would always be an ample supply available for buyers and sellers without any threat of volatility.

it is in the market for U.S. Treasuries, typically the most liquid of bond markets, that we can see the most pronounced trend of declining liquidity, as post - crisis trading has fallen a massive 70 percent

But new reforms like Dodd – Frank a nd Basel I/II/III have increased the amount of capital these institutions (mainly the largest investment banks and private – equity firms) must keep under their mattresses in case of a very rainy day. As a result, they have less money to make markets, their bond inventories shrink, and illiquidity worsens.

This creates a domino effect, as investors frustrated by bond volatility turn to alternatives that require less capital, like futures contracts on those same bonds, which in turn lowers bond trading volume and makes the market even less liquid.

Put another way, volatility is what has resulted when Federal Reserve policy designed to increase certain types of risk – taking met regulatory policy designed to tamp it down. This pattern is especially relevant now, as the Fed debates when to raise interest rates for the first time in nine years.

Though underwhelming economic growth this year has rendered a June increase unlikely, the market is still in full “wait – and – see” mode for a rise it sees as imminent.

Rate Raising with Fingers Crossed

One question, then, concerns just how much control the Fed’s pace of rate increases can ward off wild swings in the bond market. Based on that market’s current picture, however, the answer may simply be: it can’t.

As noted in the Deutsche Bank study, “It is a point of debate how far and how fast the Fed is going to be able to raise short – term rates, given the prevailing weak macro envir onment and a potential for negative side effects of higher volatility. But volatility itself could, and most likely will, materialize from their attempt of doing so, even if a lesson from this experience is that six – plus years of zero rates would make it i ncredibly difficult to raise rates in early stages of a liftoff without disrupting the market.

The point is that failure to raise rates materially does not by itself protect us from higher volatility impacting the Treasury market first and [the investment – grade/high – yield corporate bond] market next. In fact such a failure would probably mean that volatility was just too high for the market and the economy to be able to cope with it.” 4

After such a protracted period of low rates, it stands to reason that the market has grown accustomed to the status quo. Disruption of that status quo will make an unstable situation even more precarious, leaving the biggest challenge for investors being h ow best to avoid it.

No matter how quickly or slowly the Fed does what it does, there seems little doubt that a storm is coming. The most pertinent question for investors then is how fast they can build the best possible shelter in the limited time they have. With that in mind , something tells me derivatives contracts are not about to go out of style anytime soon.

 

 

 

1 Alloway , Tracy. “Everyone’s Been Worried About Liquidity in the Wrong Bond Market.” Bloomberg .com , 1 June 2015. http://www.bloomberg.com/news/articles/2015 – 06 – 01/everyone – s – been – worried – about – liquidity – in – the – wrong – bond – market
2 Ibid
3 Barton, Susanne Walker and Anchalee Worrachate. “Bond Dealers Enfeebled as Liquidity Woes Boost Derivatives.” Bloomberg.com, 31 May 2015. 
4 Alloway