Given the elevated level of market volatility in the last few weeks, we thought now would be an opportune time to update our clients on our thinking around a popular topic surrounding the bond markets: liquidity. See our thoughts below. In short, since our founding 13 years ago, we’ve been through a number of market cycles and have seen incredible changes in the structure of the U.S. financial markets. While the flavor of this recent bout of market volatility is different from those of the past, the substance is not, and we continue to feel confident on our ability to add value to our client portfolios throughout market cycles, no matter what new “challenge” the market may throw our way.
Is Liquidity in the U.S. Bond Market Really Gone?
When the popular financial press picks up a news story, particularly one that involves a potential threat to investors, we can reasonably expect to become inundated with headlines and articles on that topic for months on end. Such is the case these days with the topic of liquidity, or lack thereof, in the U.S. bond market. The stories started in October of 2014, when U.S. Treasury Bonds experienced the bond market equivalent of a “flash crash,” as yields fell and prices rose sharply in a period of just minutes. This volatile, once-in-three-billion-years event (statistically it was a 7 standard deviation yield change), coupled with major bond investors such as Blackrock and PIMCO publically sounding the alarm on market liquidity, have caused many investors to question how well their portfolio is protected from a less liquid market environment. In this piece, we explore why this has become a hot topic, what liquidity actually means, whether liquidity has actually fallen, how our clients are meaningfully insulated from such illiquidity and the opportunities that may arise from this new market environment.
Why Is Liquidity Such a Hot Topic?
The events of 2008 spurred congressional leaders and regulators to enact rules and regulations aimed at preventing the risky behavior from banks and brokers that led to the bankruptcy of Lehman Brothers and a near collapse of the financial markets. Washington’s answer to the problem has been to limit the amount of risk-taking banks and brokers can engage in. Regulations such as Dodd-Frank http://www.sifma.org/issues/regulatory-reform/dodd-frank-rulemaking/overview/, Liquidity Coverage Ratio Requirements http://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-51.html and stricter Basel Capital Requirements http://www.federalreserve.gov/bankinforeg/basel/USImplementation.htm have made it prohibitively expensive for banks and brokers to participate in the financial markets in the way they once had. As such, broker-dealers have reduced their bond inventory significantly since the financial crisis. This is particularly true in the corporate and municipal markets, but to a lesser extent in the Treasury markets as well.
How Is Liquidity Measured?
In very simple terms, liquidity can be thought of in the following ways:
- The time it takes to transact a given security
- The price variance of the transaction from the market price
Put another way by Fed Governor Kevin Warsh in 2007, “An asset’s liquidity is defined by its ability to be transformed into another asset without loss of value.”
These definitions of liquidity can be measured by statistics such as average daily trading volume and the bid-ask spread (the difference between the price at which an investor can purchase a bond and where they can sell it).
Has Liquidity Actually Diminished?
Based on the definition above, no.
Average trading costs have been declining, and we can’t find any statistical evidence to support the notion that trading is taking longer today than its pre-crisis average. As the bond market has grown in recent years, trading volumes have grown right along with it. This is particularly true for corporate bonds.
Trading volumes of corporate bonds 2006-present:
In the Treasury market, average daily trading volume has declined by 1.3% annually since 2008, but this is likely due to the Federal Reserve becoming a dominant player in the market. Through their three quantitative easing programs, the Fed has accumulated nearly $2.5 trillion of Treasury bonds, which they do not actively trade.
In the municipal market, average daily trading volumes have declined by 10% annually since 2008, but we don’t see any noticeable difference in bid-ask spreads today versus seven years ago. In fact, we would argue that liquidity has remained stable in recent quarters despite the decline in volumes. We keep close watch on the number of brokers who are submitting bids for the bonds we are selling, and haven’t seen a noticeable change.
If We Are Wrong and Liquidity Is Actually Lower, Are SNW Separately Managed Bond Portfolios Protected?
In a recent report, the ratings agency Standard and Poor’s attempted to classify the risk of low liquidity to different segments of the fixed income markets. Interestingly enough, it is the pooled investment products such as bond mutual funds and ETFs that carry the most structural liquidity risk. The reason is that these products promise instant liquidity in an investment sector that doesn’t trade on an exchange.
While separately managed bond accounts aren’t listed on the chart, we’d place them in the lower left hand side of the matrix, with low structural liquidity risks and high capacity to absorb a shock. The reason? We have the ability to hold bonds all the way to maturity. We are likely to transact less in our client portfolios during volatile market environments, which helps insulate our clients from the high trading costs that can occur in less liquid markets.
Do These Trends Create Opportunity?
In one word, yes. We continue to maintain an investment philosophy that centers on taking risk only when we are being properly compensated to do so. This risk compensation, which is generally measured in credit spreads (the difference in yield between a given bond and a risk-free bond), has declined markedly in the last few years across most sectors of municipal and corporate bond markets. In that vein, our portfolios are positioned very conservatively, with a number of very high quality, low-risk bonds. These are the types of bonds that generally receive fair pricing regardless of the market environment and can be sold quickly to purchase bonds that are being punished due to herd behavior.
This type of herd event presented itself in the municipal market in late-2010, when banking analyst Meredith Whitney, on the news program 60-minutes http://www.cbsnews.com/news/state-budgets-the-day-of-reckoning/, predicted billions of dollars of municipal bond defaults during 2011. A massive market sell-off occurred, as retail investors rushed to sell their munis in fear of default. We believe that events like 2010 can provide opportunities for us to find solid credits at attractive valuations. While mutual fund managers are forced sellers because of mass redemptions, we are able to be selective buyers.
We stand ready to take advantage of similar volatility. So, when the newspapers are printing those worrisome stories and the anchors on CNBC are saying sell everything, know that we’ll be in the market looking for attractively priced bonds that will provide benefits for years to come.
Sources: Bloomberg, CBS News, Citigroup, Federal Reserve, Market Axess, OCC, SIFMA, S&P, Trace, US Treasury