Bond stampede fear spurs race for reform

June 17, 2013 5:53 pm

Bond stampede fear spurs race for reform

By Stephen Foley, Vivianne Rodrigues and Tracy Alloway in New York

If there is one thing that keeps bond investors awake at night, it is the fear of a stampede for the exit. And for good reason: there could be a pile-up in the doorway, leading to extreme market swings. After the scares of the past month, the race is on to find ways to improve liquidity in the bond market, where, unlike stocks, it can often be tricky to find buyers and sellers. Ben Bernanke, Federal Reserve chairman, is expected this week to try to undo some of the concerns about a disorderly rise in interest rates, which he triggered in May with talk that the US central bank may begin to taper its monetary stimulus. That led to a run-up in market rates and record weekly outflows from fixed-income funds.Calm may be restored for now, but market operators are urgently promoting ways to make it easier to trade corporate bonds, in case an eventual change in Fed policy causes investors to dump more of their holdings in a hurry.

BlackRock, the world’s largest fund manager, with $3.8tn under management, on Monday revealed its own medium-term solution. It is urging companies to put bond issuance on a regular schedule, just as the US Treasury does with government bond sales, and standardise corporate bonds.

The idea is that, the more comparable these investments are, the more willing people will be to trade them in the secondary market. At the moment, big issuers such as General Electric or JPMorgan Chase can have more than 1,000 different bonds outstanding, all offering different interest rates and maturing at different times, yet only a tiny handful trade regularly.

“Fewer bonds mean lower regulatory costs and standardisation could lower financing costs” for issuers, BlackRock says in a white paper. For investors, it would mean lower transaction costs, access to more bonds and the ability to buy and sell in size.

It could be an uphill battle to make the switch to standardisation, however, according to some bankers. One bond specialist at a large investment bank says issuers might balk at the idea of having their debt maturing in large chunks at regular intervals.

“Corporate treasurers don’t want to be on the hook for those refinancings,” he says.

Fewer bonds mean lower regulatory costs and standardisation could lower financing costs for issuers

– BlackRock’s white paper

And Fred Ponzo, founder of Greyspark Partners, a capital markets consultancy, says issuers “care about the primary issuance – can they borrow the money they need? After that, the secondary liquidity is of very little concern to them.”

Nonetheless, improving liquidity in the bond market has moved to the top of investors’ agenda because Wall Street banks are retrenching. Banks hold fewer corporate bonds in their trading books today than they did a decade ago when the market was much smaller, 75 per cent less than the peak in 2007, according to Fed data, and 45 per cent less according to an analysis by Goldman Sachs that strips out mortgage securities.

Mark Howard, head of US credit strategy at BNP Paribas, says the shrinkage has contributed to increased market volatility: “When volatility is jumping and liquidity is also drying up, large dealers used to be able to step in and help stabilise markets by adding liquidity.”

Privately, many dealers say they want to band together to create a multi-dealer electronic trading platform that would mimic the quick and easy trading seen in the stock market. Banks including Goldman Sachs and Morgan Stanley have created electronic bond platforms for their clients. Private firms are trying to get traction for independent platforms.

An added risk is that this will be the first turn in the interest rate cycle since the arrival of exchange traded funds (ETFs), now substantial holders of big corporate bond issues.

Investors can buy or sell ETFs as if they are shares, much faster than the ETFs themselves can buy or sell the underlying bonds in their own portfolios. Mark Wiedman, head of BlackRock’s ETF business iShares, says ETFs could in fact be a source of liquidity, since they allow people to trade baskets of bonds on the stock market through the day and quickly find the right new price for these assets when the market turns, all without actually having to assemble the underlying assets.

Others argue that ETF holders may be more likely to bolt from bond markets than traditional bond investors, exacerbating price declines. But that is a notion Mr Wiedman dismisses with a quip.

“And ETFs cause global warming, too,” he says, adding: “The minimum liquidity of an ETF is the liquidity of the underlying, but the liquidity could be significantly higher than that.”

Peter Tchir, founder of TF Market Advisors, worries that the liquidity mismatch between fixed-income ETFs and the underlying bond market could lead to a “death spiral”, something he believes was in play during a plunge in the gold price in April.

When an ETF appears to trade cheaper than the value of its underlying assets, it tempts arbitrageurs to buy the ETF and sell the underlying bonds.

However, if those underlying assets are illiquid, sales can have an outsize impact on values, in turn prompting panic selling of the ETF.

Such are the nightmares raised by the bond market volatility of the past month. And whatever the soothing words tomorrow from Mr Bernanke on Wednesday, market operators are more frightened than they have been for many years.