Wednesday, June 20, 2012

The Importance of the Boring World of Corporate Bonds

Years ago, when I was involved in managing corporate bond portfolios, I was interviewed about the bond market by the Wall Street Journal.

I had recently gotten married, so when I got home that night and told my wife that I had been interviewed she said that she would make a point of reading the article when it appeared.

But when I showed her my interview the next day, and she started reading, her attention quickly waned.

Finally she looked up from the paper and said with a sigh:

"God, this is boring."

Active management of bonds is a relatively recent phenomenon.

When I started in the investment business in 1982, bonds were mostly held to maturity, as they had been for decades.

Trading or selling bonds was a relatively clunky activity, mostly done over the phone with a handful of dealers.  Bid/ask spreads were wide, and the concessions to sell smaller bond positions could be significant.

This changed in the next couple of decades.  Billions of dollars of bonds are traded easily on a daily basis with a variety of different dealers.

As technology enabled bond settlements to be handled as simply as equity trades, institutional bond managers actively managed their clients' portfolios, and were judged against a wide variety of bond market benchmarks that had only recently been developed.

However, as my post yesterday indicated, secondary bond market liquidity is gradually disappearing, especially for issuers whose credits are either less stellar or businesses are less well known.

The Financial Times had a long piece about corporate bonds this morning.  Here's an excerpt:

The problem centres on large investment and asset management companies, known as the "buy side". These are flush with cash and have sought to expand their massive portfolios with corporate debt.  However, they are finding harder to purchase or sell bonds from "dealer" banks that act as the middleman, the so-called "buy side".

If investment funds have to spend more to trade, they could ultimately pass on their increased costs to companies whose debt they buy.

The banks cannot satisfy the buy-side's needs because they are reducing their own holdings of corporate bonds, partly because of a raft of new regulations proposed in the wake of the financial crisis.

Now, to be sure, the subject of bonds is probably no more interesting to most people than it was to my wife a couple of decades ago.

But it is important. 

Higher corporate borrowing rates can obviously have a negative impact on economic activity.

In addition, bonds of all types play an important role in millions of investment portfolios.  Most investors holding bonds or bond mutual funds today assume that their positions could easily be liquidated in the need arises.

But what if there is no bid?