Michael Santoli

Balky Bond-Market Plumbing Is a Big, Hidden Risk

Michael Santoli

It’s time to worry about the bond market.

This isn’t an investment call tied to familiar concerns over Federal Reserve actions, possible higher interest rates or rising inflation.

Rather, investors should worry about a less-discussed reality: The structure of the bond market itself is balky and vulnerable to bouts of exacerbated investor losses and trading air pockets, simply because the act of trading corporate bonds among funds and banks has become tougher and less-efficient since the financial crisis.

Even as companies have taken advantage of all-time-low rates to issue record amounts of debt gobbled up by yield-starved investors, trading volume in bonds has lagged and the market is too unsteady to absorb any bouts of heavy selling without outsized volatility.

A bronze bond market

The issue is one of financial plumbing, a system lacking the valves, seals and pipe strength to handle the pressure of a bond-market downturn. As Vincent Gardenia’s plumbing contractor in the film “Moonstruck” tells a customer as he up-sells him to copper pipe: “There’s bronze, which is pretty good — unless something goes wrong. And something always goes wrong.” We now have a bronze bond market.

The bond market’s structural vulnerability has grown out of three distinct trends:

1. Wall Street banks that historically have mediated bond trading have pulled back, in part due to regulatory changes. Bond dealers are carrying less in corporate bonds on their books than they have in years, especially when compared to the surge in corporate debt outstanding.

Inventories of corporate bonds among the big Wall Street banks known as primary dealers totaled $100 billion in 2004 and more than $200 billion at their 2007 peak, according to the Federal Reserve Bank of New York. Today, in a larger overall market, dealers hold just over $50 billion.

Low corporate-bond inventories reflect in part the ban on banks’ proprietary trading with their own money by the Dodd-Frank post-crisis financial-reform law, as well as the broader mandate for banks to carry more expensive capital against trading books. The leaner inventories and stiffer capital rules mean banks are less willing and able to actively take the other side of institutional clients’ bond trades.

Electronic trading venues have become more active in matching buyers and sellers, but they don’t deploy capital in the service of smoothing the exchange of the thousands of discrete credit instruments on the market, the way “sell-side” banks traditionally have.

Richard Prager, head of trading and liquidity strategies for BlackRock Inc. (BLK), the nation’s largest asset manager with $4 trillion under its control, says: “What scares me and really what the reality is, is that there’s not enough balance sheet on the ‘sell side’ to support any kind of warehousing activity if institutional investors want to materially reduce their holdings.”

He’s concerned about a “structural asymmetry” in the fixed-income market: “It’s fine when there are [mostly] buyers, but not when there are sellers.”

A complacent market

Bonds have become a complacent, buy-and-hold market. More than $1 trillion in net new money has flowed into bond mutual funds since 2008 as investors gained confidence in the safety-and-income trade. More than $1 trillion in new bonds has been issued by companies in each of the past three years, and this year is running ahead of last year’s record pace.

The volume of newly offered bonds has routinely amounted to 20% or more of the total amount of bonds outstanding. By contrast, only 1% of stock market value is issued in the form of new stock offerings most years.

And yet this vast quantity of new bonds grabbed up by yield-hungry buyers hardly ever trades, following an initial flurry when they first hit the market. The annual trading volume in all investment-grade corporate bonds relative to the size of the total market is at a decade low – down some 40% in velocity since 2007, says electronic bond-trading venue MarketAxess.

The result is a market in which freshly offered bonds are bought, trade fairly actively for a short period of time and then become “museum pieces,” in Prager’s phrase, figuratively hung on a wall to be gazed at until maturity.

[The Treasury market is undergoing its own distortions thanks to the Fed's outsized role in absorbing government-bond supply and the resulting thinning of bank trading inventories. Yet this is largely a separate issue from those facing credit markets.]

2. The steady strengthening of bond values (and attendant decline in yields) has made this buy-and-hold habit acceptable to nearly everyone, with investors happy to sit quietly on their appreciating bond portfolios. This arrangement works fine until people decide the market is turning, and funds are hit with big withdrawals while firms need to start selling these pieces promptly. Prices will inevitably suffer and much will be lost in the turnover.

3. The rise of ETFs is creating distortions in the market. Bond index exchange-traded funds are an impressive innovation, allowing small investors to own broad exposure to fixed-income assets at low cost with minute-to-minute ability to get in or out.

Yet, especially with regard to the high-yield — or “junk” — sector, the ETFs have become quite large for the underlying market, and they allow for a velocity of money rushing in and out that often exceeds the typical liquidity of junk debt itself. The iShares iBoxx $ High Yield Corporate Bond fund (HYG) and the SPDR Barclays High Yield Bond fund (JNK) together have $27 billion in assets, and their shares trade an average of more than $500 million a day.

The total U.S. high-yield bond market trades some $6 billion on an average day, according to trade group SIFMA. Trades in the ETF do not necessitate buying and selling of actual bonds in the fund, and – once more – in calm markets the setup isn’t a problem.

Yet one result is that particular bonds issued by a given company will trade at a big premium based on whether it is in a bond index and/or is more liquid. And when flows into and out of the junk ETF are heavy, it creates excessive demand for, or pressure on, specific scarce bonds.

Ed Perks, manager of the Franklin Income Fund (FKINX), reports that, on such days, brokers will circulate lists of bonds with “bid wanted” or “offer wanted” as the ETFs scramble to reallocate their portfolios.

In the recent spooking of the credit markets and backup in Treasury yields, these ETFs have at times traded at discounts to the net asset value of their holdings, a cautionary sign of what could happen in an outright panic.

As far as remedies, Prager at BlackRock is promoting through a forthcoming research paper that heavy issuers — such as General Electric Co. (GE), AT&T Corp. (T) and the large banks, which have dozens or hundreds of separate bond issues in circulation — should work toward standardizing bond issues and selling debt at fixed intervals. This could make benchmark bond issues more fungible and easily traded, the way stocks are.

The markets for credit-default swaps and mortgage bonds have benefited greatly from efforts toward standardized terms and trading procedures. And corporate issuers could save money on fees and regulatory paperwork under the BlackRock-supported practice. Electronic order-matching platforms should also work toward better investor-to-investor order-matching technology.

These tweaks could help the situation over time. But they’re unlikely to take hold before the bond market gets its next test, when unwary investors sitting on profits get spooked if fundamental conditions change quickly.

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