Liquidity Crunch Time Coming For Bonds

This is probably the last thing banks will tell their hard earned bond customers and rightly so, because warnings often come as the fine print in those lengthy pages of documents we are all made to sign to absolve banks of misdoing in the wake of the great financial crisis of 2008.

The bond market has changed and we have a new breed of investors these days – the retail buyer. The only growing market segment these days as banks’ proprietary desks are shuttered and institutional clients run off in pursuit of funkier instruments and corporations issue bonds to buy back their shares.

In the past, retail involvement came mostly through the form of collective investment schemes – the unit trusts, ETFs, funds and invesment linked insurance policies.

FT : “During the past five years, credit markets have attracted less experienced investors who switched from low-yielding Treasury bonds and money market funds to investment-grade and high-yield debt.”

Locally we comments like these below.

“There could be concern as to whether the bond investors actually do their homework in some of these new issuances, especially the new ones in the midcap”: Liew (Source : Bloomberg )

Direct retail purchases are on the rise and will continue to rise as banks need to sell those bonds to someone, to the extent of pushing the popular leverage play to enhance yields by lending money to customers to buy bonds and thus, increasing their returns and guaranteeing bank profits.

These retail investors who would have mostly missed the bond crises of the past, unless we count that minor skirmish we had in June and Sept last year.

Morningstar EM HY Bond Total Return Index

Morningstar EM HY Bond Total Return Index

 

Whilst I advocate the greater role bonds will play in portfolios in the near future and that the landscape of investing is changing with many more self managed investment accounts as the ranks of the wealthy swell and retirement/legacy planning take precedence, I believe that expectations are building for rate normalisation in the future even as we have ECB just embarking on a 2 year bond buying campaign.

The bond market is simply too hard to ignore especially if we consider that the investment returns on US treasuries have returned $ 1 trillion to investors since 2008. http://www.bloomberg.com/news/2014-09-08/you-missed-1-trillion-return-agreeing-with-fed-naysayers.html

Yet there is growing evidence that we are headed towards stale markets for bonds with banks increasingly incapable of providing liquidity for the papers that they sell due to crimping new regulations on balance sheets, proprietary trading and capital maintenance.

“While the size of the U.S. bond market ballooned by more than $5 trillion since 2008 to $37.8 trillion at year-end, trading in the debt has slumped, according to data from the Securities Industry & Financial Markets Association. Average daily turnover fell to $809 billion last year from $1.04
trillion in 2008.” http://www.bloomberg.com/news/2014-09-22/shrinking-bond-desks-taken-by-journeymen-as-masters-fade.html

Some of the ingredients in the recipe for disaster.

Shrinking Margins
As the OTC market becomes transparent, firmly policed by new rules for banks to reveal fees and mark ups, the margins for selling bonds gets vastly reduced. Banks simply have little incentive to sell bonds other than in the primary market during the issuance phase.
http://www.businessweek.com/news/2014-07-16/bond-fee-disclosures-sought-by-sec-to-end-38-year-debate

https://tradehaven.net/market/bond-market-developments-more-good-news/

Size
AUM of bond funds have swelled. For instance, the AUM at EU high yield bond funds have grown from €12 bio in 2009 to €57 bio. The number is even larger for the US based funds.

Junk bond issuance is at a record as investor reach for yield and fore go usual safeguards. According to the S&P rating agency, 50% of all rated global corporate debt issuers are “speculative” grades.

Even global investment grade deals total some $2.28 trillion this year so far, a new record high before the year end.

Bubble Warnings
After a stellar performance, the experts are finally calling a bubble in bond spreads and junk yields.

Take this chart for example, from Citi Research, which shows that leverage does not affect credit spreads these days indicating investors are not bothered by heavily borrowed companies.

CREDIT SPREADS AND LEVERAGEMoody’s noted that spreads continue to widen despite more upgrades than downgrades and to proceed with caution as debt outruns profits ! https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_176097

Folks are listening because the HYG US ETF, a high yield bond ETF, has fallen substantially off its highs of the year.

HYG US

Why is this of any consequence ?

Well, I have heard that the reason behind the Russell 2000 fall has been HYG.

Hedge funds and bond managers who have illiquid junk bonds have taken to selling the Russell 2000 mid cap index to hedge their bond holdings which nobody would take off their hands.

russell and hygNote the symmetry in their moves in the recent months.

This strategy works as an interim measure but bonds will have to be sold one day when funds get redeemed. That would be a good test then.

Absence of Bond Traders
A Bloomberg article published some weeks back struck a chord in me for it is a stark reminder of the state of affairs (which is why my friends complain that I have few bond recommendations for them).

Titled Shrinking Bond Desks Taken By Journeymen As Masters Fade, I would not call it a critique of the current batch of bond traders sitting on the flow desks. It is more of a reminder of how few of them have seen or traded through a crisis in their lives.

Anyone with 5 years or less of experience would not have witnessed Lehman and for those who have, anyone with less than 10 years of experience would not have seen the Gulf war, SARS, let alone the September 11 WTC attack, the Asian Financial Crisis and dot com busts before that.

We can argue that all crises are different which I tend to agree. But the emotions and herd behaviour, are almost always exactly the same.

Volatility Is Back
After months of waiting in a one dimensional, one directional runaway market, vols were decimated.

The VIX index is now trading above its 12 month average at 15.46 and markets are back in business which means bankers can start marketing their derivatives structures to clients.

vix

Fx, equities, commodities and rates vols are bouncing back strong and it looks like all those accumulators will be back !

Liquidity Trap Time

In the past months, we have had quite a few alerts of out Blackrock, the world’s largest money manager, the FT, Julian Robertson and more, all highlighting 1 problem – the liquidity trap.

The liquidity trap works like this …

“…banks are now less able to facilitate trading in secondary markets, bound by stricter regulation and higher capital requirements. Low liquidity can “trap” sellers, accelerating price falls.” http://www.zerohedge.com/news/2014-09-23/blackstone-slams-broken-bond-market-despite-record-bond-issuance-driven-stock-buybac

I have heard many people tell me that they do not care about their bond portfolios. It is a buy and hold strategy, they have heaps of cash and only buy short dated bonds and they don’t leverage so they are fine.

I personally would feel foolish if I had a bond portfolio that rallied 4% in price terms and did not do anything about it only to watch it fall into a loss.

I am certain that there is a liquidity crunch coming. The signs are building up into year end when banks have less balance sheet to play with, as the final taper of Fed’s QE comes in next month and ECB’s stimulus only seem to have an effect on forex rates.

PIMCO saw massive withdrawals last month after Bill Gross exited the company. There is quite a lot of paper in the street right now even as the market braces for more Chinese issuance before the year closes.

Financing is getting difficult as Ben Bernanke revealed that even he had trouble refinancing his mortgage. http://money.cnn.com/2014/10/03/real_estate/bernanke-refinance/

My parting words of advice : Stay nimble.