Potential problems from bond illiquidity seem to have acquired the status of a fear du jure. That characterization in no way means to belittle popular concerns. On the contrary, if illiquidity does not yet top the list of threats to financial markets, sufficient signs have emerged to justify today’s worries, especially about how a concerted move in bond markets, say when the Federal Reserve (Fed) raises interest rates, might produce disruptive execution delays and extreme price moves. Reason might question some of that more apocalyptic characterizations of the problem, but a lack of liquidity is never good. Nor is the disorderly pricing it can precipitate.
Causes and Signs
Illiquidity problems seem to have many roots. At base is the simple fact that bond volumes have outgrown the ways most bonds still trade, which, in today’s computerized world, can only be described as cumbersome. The customary and still dominant approach depends largely on the willingness of bond dealers and investment banks to use their own capital to acquire an inventory of bonds. Potential buyers and sellers than talk on the telephone to representatives of these trading firms to see if they want to buy anything from that inventory at the asking price, or, alternatively, if the dealer will offer them a good price to take one of their bonds into that inventory. It is a time consuming process, particularly ill-equipped to cope with the recent growth of bond volumes. Outstanding investment-grade bonds in the United States have jumped 90 percent over just the last 5 years and volumes have risen 83 percent jump in Europe over just the last 2 ½ years. In the customary system, coping would demand a huge additional commitment in capital by dealers and many more employees to man many more telephones, something that even the most enthusiastic of them would hesitate doing, even under the best of circumstances.
And circumstances are far from the best. Instead of expanding their facilities, dealers today find themselves under tremendous pressure to cut back. Part of that pressure comes from within. None want to relive the 2007-08 financial crisis, when aggressive positioning caused bankruptcies, near bankruptcies, and the need for bailouts. What is still more significant, all face powerful regulatory pressure to reduce their risk exposure, from the Dodd-Frank financial reform legislation in the United States, the Markets in Financial Instruments Directive (MiFID) in Europe, and globally from the Bank for International Settlements’ (BIS) so-called Basel III rules. These regulators not only discourage risk taking and large bond inventories, they actually impose penalties of various kinds on firms that would extend themselves to accommodate markets. Indeed, Dodd-Frank’s so-called Volcker Rule actually forbids deposit taking institutions from building an inventory, insisting that they only serve immediate customer demands.
Some have argued against these regulatory efforts. They claim that such rules do less to erase risk than to transfer it from dealers and investment banks to bond holders by depriving them of the liquidity they need. Whatever the truth of this matter, it is plain that the milieu has constrained conventional trading abilities even as greater volumes of issuance and bonds outstanding have increased the need. Federal Reserve data suggests that not only have the number of dealers declined, but more significantly, the average bond-trading inventory has dropped from just under $400 million in 2007 to less than $100 million at the end of 2014, with declines registered in corporate, agency, and treasury securities. Such statistics are not available for Europe, but Bloomberg Business reports that on average of only 3.2 firms offered bids on bonds there recently, down from 8.8 in 2009.
Liquidity has suffered in other ways as well. Bonds seem to trade in smaller amounts than they once did, no doubt because of the growth of bond mutual funds and ETFs. According to data provided by the Securities Industry and Financial Markets Association (SIFMA), the average bond trade in the past year equaled $536,000, down 43 percent from the $948,000 averaged in 2007. This circumstance would demand more of those trading conversations and still more diverse inventories even if overall volumes had not grown, which, of course, they have. At the same time, the growth of bond mutual funds has raised the number of bond managers that need to move into and out of bonds on a daily basis. Funds with daily redemption requirements already make up 46 percent of the investor base globally. In the United States, they have doubled their share of the market in just the last nine years. If this were not enough pressure, the increasing dominance of central banks in markets has encouraged herding behavior among bond holders, a pattern that causes trades cluster at times on the buy or the sell side and so strain liquidity still more by demanding still more extensive inventories.
It should hardly surprise, then, that trading volumes have fallen relative to the size of markets and their presumed needs. In the United States, annual trading in high yield bonds has dropped from 1.2 times volumes outstanding in 2006 to only 0.7 times presently, effectively a 42 percent liquidity drop on this accounting. Investment grade bonds have seen an even bigger relative decline. There, annual trades have dropped over the same period from 1.5 times outstanding volumes to 0.4 times, a 73 percent liquidity decline. Treasuries have seen a 71 percent drop on this same basis. Other data show trading in treasuries was only 3.3 times annual issuance recently compared with 7.0 times in 2002. And the picture is not that much different overseas. Trading in Japanese government bonds has dropped during this time 17 percent relative to the volume of such bonds outstanding. Trading in British government bonds, the so-called gilts, has dropped 47 percent by this measure. Matters seem less extreme in the German government bond markets, where trading has dropped only 3.3 percent relative to outstanding amounts, but the direction is still clearly toward illiquidity.
Strains and Mitigators
This situation threatens at a most fundamental level, both the way each economy finances much of its business and the way millions of individual investors, pension funds, and endowments manage the assets in their care. An immediate concern is that the lack of liquidity will make trading more costly. There are signs that such pressures are beginning to build. The so-called bid-ask spread, the difference between what dealers charge bond purchasers or will pay bond sellers for the same bond, has widened. Treasuries have only seen a slight increase, but, according to Thomson Reuters, the strain is clearly evident in investment-grade corporate bonds, where such spreads on average have increased from less than 8 basis points in 2012 and 2013 to slightly over 9 basis points by late 2014 and in 2015, an 18 percent increase in costs.
A more significant fear, however, centers on what would happen if circumstances were to demand a lot of trading, say after the Fed begins to raise interest rates. Then, large groups of bond holders would likely want to adjust the composition of their holdings and will consequently generate large numbers of trades. These, facing constrained liquidity, may well take more time to complete than most investors would like. No doubt such pressures would penalize large pools of assets more than small. They, after all, have more to move through a narrowed trading conduit. But if smaller bond pools are more likely than larger pools to get their trading done in a reasonable time, all will suffer from extreme price moves, for constrained liquidity always prompt dealers to ration their time and their limited inventories asking more of purchases and offering less to sellers. Some large pools of bonds, though not all, have become concerned enough about the prospect to set more money aside now to meet prospective redemption demands. Though prudent in one respect, such practices cost the fund’s beneficiaries by keeping a greater portion of their assets idle than otherwise.
Some contend that this prospective problem might turn out to be less severe than it seems on the surface. They point to the growth of electronic trading in bonds. Its application to equities certainly has enabled that market to handle volumes today that would have shut trading down in the past. Of course, the matter with bonds is not so simple. Because they have less uniform characteristics than do equities, they yield less readily to the standardized treatments unavoidably imposed by computerized arrangements. Still, electronic approaches that match buyers and sellers have gained recent prominence in bond trading, especially for larger blocks of assets. Some firms have set up systems designed to find buy and sell matches within their own customer base. With the Financial Industry Regulatory Authority (FINRA) taking an increasing interest, there is reason to expect some further progress on these fronts.
Not all hopes for relief involve electronic trading. The inadequacy of traditional dealer networks could well induce other firms to enter the business. There is every reason, for instance, to expect an increase in agency trading in which people put buyers and sellers together, electronically and otherwise, collecting a commission for the service instead of acting, as in the traditional manner, in the capacity of a principal who uses its own capital to maintain an inventory. Some suggest that large institutional investors, pension funds primarily, will make arrangements, either on an agency basis or even with their own capital, to ensure adequate liquidity. Such moves might look attractive in the circumstance because they not only would provide needed liquidity but would also would save these institutions the expense of the bid-asked spread that more traditional trading practices give to the dealer. The rapid growth of closed-end, exchange traded funds (ETFs) might act as a source of relief, too. These funds own bonds but, unlike open-ended arrangements, have no need to sell or buy them immediately as their holders respectively redeem their shares or seek to buy into the fund. Still, this cushion is only so thick. In the face of concerted sales or buys, even such funds would have respectively to offload some of their holding or increase them.
Solutions & Prospects
Just as no one yet knows how much pressure might develop from liquidity shortages, neither does anyone know how far these mitigators can relieve those prospective pressures. Beyond wait and see – hope and worry – a more permanent fix would change the way bonds trade. These would seem to include a mix of bond standardization, electronic platforms, and the encouragement of trading practices that go beyond traditional dealer-to-dealer and dealer-to-client arrangements. Given how similar efforts in the past have improved market liquidity, first in equities and then in mortgages and credit default swaps, there is reason to expect progress, eventually if not immediately. The ultimate solution would seem set to change bond markets in two significant ways:
- First is standardization among corporate bonds. This would include more set calendars, amounts, and maturities, with fewer covenants and call provisions. Such a change would not only facilitate the adoption of electronic trading platforms, but it would also make the current system more efficient, and it would facilitate the growth of other agency approaches.
- Second is an increase in information and transparency. The present dealer-to-dealer, dealer-to-client approach is far less than comprehensive and much less transparent than will ultimately become necessary. Future arrangements will have to become transparent enough so that all are aware of availability at any time. Such a change would also facilitate the growth of electric platforms as well as other agency approaches to trading.
These changes, to be sure, are easier to identify than implement. There is, however, reason to expect movement in these directions as illiquidity pressures begin to increase price volatility, distort pricing, hamper timely executions, and widen bid-ask costs. Today’s angst over the subject could not offer a better catalyst for such changes. The danger is to ignore the problem.
Thirty Tomorrows 