On the beach

Alas I find myself in a similar situation to when I first started writing this blog in the beginning of 2009. Due to decisions made well above my pay grade and across the ocean, I find myself 'on the beach' once again. Before you immediately put my missive on the junk/spam filter watch list, I assure you that I will not be sending many of these. Hopefully only a handful as I have already been re-engaged by several potential future employers.

I'd like to say I'm back due to popular demand. Exactly two friends responded "good, now you can re-start your blog" when they learned of my recent departure from the payrolls of a large bank.

My first observation is a repeat of a long held belief that 'you cannot have liquidity without capital.' Take a look at this graph (Fed data) of US broker/dealer holdings of corporate bonds:

The capital provided to clients as liquidity to trade corporate bonds has fallen off a cliff. The non-capital/agency dealers must be licking their chops. However, it can take a long time for large institutional investors to alter their thinking and trading styles to a more 'patient liquidity' model.

My second observation may be overly simple and perhaps naive. There are few, if any, investors (in any asset class) that believe the European sovereign situation will improve any time soon. In my >20 year career, every single time the entire market felt the same way about a future outcome, that particular outcome rarely actually occurred. While I'm not predicting an immediate positive solution/outcome to Europe, I would posit that a 'positive' outcome would like be the most disruptive to the market. Witness early 2010 when almost every single investor (ex Rick Rieder @ Blackrock) thought US rates were going to rise dramatically. They made salient fundamental and technical arguments for why this was inevitable. Yet, the exact opposite occurred. Back to Europe, be sure to read, or re-read, Michael Lewis's very prescient article from October 2010 about Greece.

Many have observed that Wednesday night was perhaps the most exciting group of games in baseball history. The NYTimes has an article where they write that the odds of those particular game outcomes were 1 in 273 million. In addition, on a more painful and personal level, they note that the odds of the Red Sox making the playoffs, as of September 3rd, were 99.6%.

Daily commentary

Nothing seems to be in the green this morning.  Spreads and equities are both weaker.  Interest rate swap spreads and the Vix both remain stubbornly higher too.  However, I've worked with more than one trader that fervently believed that you are supposed to fade the opening move on Fridays especially when it's a large one like this.

That all being said, technical demand remains strong (just not today!).  There has been $175B in maturing bonds in the last 6 months in finance names alone....couple that with $125B in coupons paid (across all sectors) and that creates one big pile of cash that must be put to work.  The tail wind of investor inflows on exacerbates this.

Yesterday was actually quiet on the new issuance front for the first day in quite some time with only some small deals (SNA being one of them).

Gold just broke through a $1000....does that still matter when the CRB is at multi year lows?

The NY Fed reports that dealer positions in corporate bonds (not just credit, includes some agency and structured product) is at the lowest point since 2003.  Their holdings are down ~60% since Oct '07 alone.  This is further data backing the massive shift in liquidity from a dealer principal market to an agency trading market.  Some will tell you that liquidity is just fine and cite the TRACE overall market volume data....but if you take out recent new issues, you'll find that it remains weak.  When new issue volume is heavy, overall secondary volume will 'look' heavy too....but liquidity remains very concentrated in large recent new issues. As a reminder, while the agency model does get trades done....it typically takes longer as the orders need time to get worked and shown around.  That latency is difficult to quantify and gets lost in any volume numbers. 

High yield and investment grade spreads have recently de-coupled.  JPMorgan has a great graph in their recent Credit Markets Outlook showing 3 cohorts....2 with 90+ R squareds....and the third most recent cohort with an R squared close to 0.  The nationalization of the banks is likely to be the primary driver here.

 

Why an exchange model won't work for corporate bonds

Here is some data that always surprises equity investors about the difference in the liquidity profiles between the equity and debt markets.

The US equity market has ~6k publicly traded listings of which ~99% trade daily.

The US corporate market has ~600k issues of which only 3% trade in a given week.  

Please note the obvious....an issuer typically only has 1 common equity....but could have dozens or even hundreds of senior unsecured debt issues.    

If you look at the top 25 most active corporate bond issues, they typically make up about 21% of the markets overall volume.  Typically, these issues are recent new issues.  It often seems to investors that the major underwriters are bringing new issues to market, trading them briefly in the secondary and then they go to 'bond heaven' (or hell as the case may be).

So, liquidity in the credit markets is very concentrated in a few recent new issues...and beyond these issues, the volume thins dramatically.  I've seen numerous instances where ~$5oomm deals don't trade even 1 bond for weeks and sometimes months on end.

As an aside, the sectors that habitually have the worst liquidity are REITs, insurance and bonds with a maturity of less than 5 years (all sectors).  

So, say a Rohm and Haas bond with a 2029 maturity fits the profile of a potential buyer that wants to asset/liability match....but the only seller in the market of that issuer is of the Rohm and Haas 2020 maturity bonds....nary the twain shall meet.  There would not be a trade.  This is what would occur in an 'exchange model'.  Please note, that I am using the term 'exchange model' but the same holds true for a matching network model as well.  

In the 'old days', when dealers devoted capital to trading corporate bonds, a dealer would buy the 2020s in the market and (short) sell the 2029s to the client that needed them.  The 9 maturity difference would not add too much risk to their balance sheet.  The shift from principle to agency trading has virtually eliminated this service.  I've said this once before, you cannot have liquidity without capital.

There are 2 hurdles to be overcome if an exchange model is to succeed.  

One is investor preference.  It's been my experience that investors often enter the market looking for a particular bond....and not looking for 'what's available at the right price'.  There's often a good reason why only particular bond (or risk profile) is needed.  A reasonable investor does not want to accumulate a mish-mosh of small positions in one issuer (which is what could occur under the 'what's available at right price').  Given the thin liquidity profile of the bond market that I described earlier, this existing investor preference would need to change.  

Two, issuers need to reduce the number of different bonds outstanding in their name.  Re-opening an existing issue may cause a less than optimal asset/liability match for them but it will enhance the liquidity in their name.  This will allow them better access to the capital markets in the future.  

There is little economic incentive for the major participants (issuers, investors and dealers) to adapt to the measures mentioned above.  To state the obvious, most folks have far greater and more imminent problems to focus on.  Until this dissipates, don't expect liquidity to improve or an exchange model to develop.