Wednesday, September 11, 2013

The Real Risk to Bond Investors?

Verizon's mammoth debt offering of $45 billion to $49 billion in bonds has been the talk of the credit markets in recent days.

Verizon is in the process of purchasing Vodaphone's portion of Verizon Wireless for $130 billion.  While the numbers are staggering (to me, at least), Verizon feels comfortable that the combined entity will achieve sufficient cash flow to be able to regain its single-A credit rating within four years.

Verizon's debt offering is actually an eight-part offering, with a combination of fixed rate and floating-rate securities.  Most investor interest is has been on either the shorter maturity pieces or floaters, a nod to the widely held assumption that interest rates seem to be on a path to higher levels in the next few years:

Verizon may sell about $13 billion to $15 billion of fixed-and floating-rate notes maturing in three and five years, one of the people said. The three-year, fixed-rate notes may yield about 165 basis points more than similar-maturity Treasuries and the five-year debt may pay a spread of about 190 basis points. 

The company may also sell about $15 billion of seven-year and 10-year securities paying spreads of about 215 basis points and 225 basis points, the person said. It may also sell about $18 billion to $20 billion of 20- and 30-year bonds yielding about 250 and 265 basis points more than benchmarks. 

“The fear is tapering begins and rates go much higher,” Andrew Brenner, head of international fixed income for National Alliance Capital Markets in New York, said in an e-mail. “They recognize they have a window to get the bonds done.”

Interest rates are expected to move higher for a wide variety of reasons - Fed "tapering" and stronger economic growth being the most widely cited.

However, yields on corporate debt could potentially move higher than expected due to a factor that few have focused any attention:  namely, the lack of secondary market liquidity.

The Financial Times has a long piece this morning discussing how the dynamics of the bond market have changed in the aftermath of the 2008 credit crisis.

Institutional bond investors have long been accustomed to the idea that if they could sell or swap a particular bond holding for whatever reason.  Individuals who invest in fixed income exchange-traded funds (ETF's) also have become accustomed to instant liquidity.

From the perspective of Wall Street, however, fixed income trading has always been a low margin activity requiring huge dollops of capital.  As new higher capital requirements have been phased in, most major dealers have significantly reduced their commitments to fixed income trading.

Here's an excerpt from the FT article:

Liquidity is the lifeblood of any well-functioning market.  It lets investors dart quickly and easily into and out of positions without significantly moving the price of the securities they are buying or selling.  A dearth of liquidity contributed to the global financial crisis as banks were unable to offload billions of dollars worth of complex assets tainted with the stench of falling subprime mortgages...

The risk embedded in corporate bonds has now been shifted from the banks to investors.  From a regulator's standpoint, this means banks are less likely to require a bailout.  Instead of pain being inflicted on taxpayers, investors will feel it.

But with interest rates able to move in only one direction - up - many bankers and asset managers are warning that investors who have built up corporate debt positions worth billions of dollars may find the exit crowded when the 30-year bull run in bonds finally comes to an end.

In my mind, this does not mean that bonds should not continue to play a meaningful role in a balanced portfolio.

However, it does mean that investors should accept a "buy and hold" approach to many bond positions, accepting that active bond management in a less liquid world is going to be much harder to do successfully.