Thursday, February 14, 2013

Why Liquidity is the Next Concern for Bond Investors

Active management of bond portfolios is a relatively recent phenomena in the capital markets.

Bonds, of course, have been around for centuries.  However, for most of the history of capital markets, bond investors typically bought a bond, "clipped a coupon" for their interest payment every 6 months, and received their principal back at maturity.

When I started the business in 1982, there was only bond index available:  the Salomon Brothers High Grade Corporate Bond Index.

Similar to the Dow Jones Industrial Average, the Salomon Index consisted of 30 high grade bond issues (which in those days meant telecom and energy debt) whose prices were marked-to-market on a daily basis by Salomon traders.  The index was then manually computed, and reported on a weekly basis.

Technology changed everything in bonds.  With more computing power available, a wide variety of indices could be developed and reported on a daily basis.

In addition, bond trading - which was previously done only infrequently - could be easily done with a quick call to a Wall Street broker. Settlement of bonds was facilitated by the move away from issuing bonds in paper certificate form - all bonds today are held electronically, identical to stocks.

Oh, and there was one more factor:  Bond yields peaked in the early 1980's.  As interest rates gradually moved lower, investors could now enjoy equity-like returns from actively managing bond portfolios.

In the 17 years starting in 1982, while equities were returning a whopping +19% compound annual return, investors in long Treasury bonds earned +13% per annum - not bad for a "boring" bond investment.

Underlying this trend in active bond management was the implicit understanding that bonds could be bought or sold at any time. Wall Street stood ready to make a market in most bonds, so really the only decision for bond investors was how to structure portfolios.

The credit crisis of 2008-09 changed all of this.

New regulations enacted over the past couple of years have increased the capital requirements for money center banks as well as brokers.  Bond trading - traditionally a low margin business that prospered only if trading volumes were high - has suffered.

Today, investors can still buy and sell bonds, but the Street will normally now "take the order" and market bonds on behalf of clients. In some cases, where a bond issue might be small, or the issuer less known, selling a bond might take a day or two as dealers scour their client base for a buyer. In some cases, there might not be a bid at all.

Bonds, of course, have been hugely popular in the past five years, as I have written on numerous occasions on this blog.  When the money flows have all been into bonds, dealers have been more than happy to provide product.

But what happens if investors want to sell bonds? What if the "Great Rotation" from bond mutual funds to stock mutual funds become a tsunami?

More and more professional bond investors are worried about the lack of liquidity these days, and are taking steps to hopefully make their portfolios less vulnerable.

According to a recent article in Institutional Investor, a number of investment shops are turning to exchange-traded funds (ETFs) for their bond positions. They hope to avoid the potential illiquidity in individual bonds positions should their client base decide to reduce fixed income exposure.

Here's an excerpt from the piece:

In the wake of the financial crisis, the big banks have only committed a fraction of the capital needed to maintain orderly and liquid fixed-income markets.  Thanks to regulations that compel banks to hold a certain amount of reserves, and proposals like the U.S. government's Volcker rule that force banks out of proprietary trading, investors find it much harder to buy and sell fixed-income securities. "The question is, how will the buy side manage the liquidity risk of their fixed-income portfolios once interest rates start to rise and net asset valuations get hit?" says Will Rhode, New York-based director of fixed income research at research firm TABB Group.