Corporate debt has been one of the slam-dunk investments of the post-financial crisis era, handing investors juicy and stable returns. As a result, billions of dollars have gushed into the market. But some fear the party is about to result in an
epic hangover.
Simmering skittishness over the US corporate bond market morphed into near-panic earlier this month, when a small high-yield bond mutual fund abruptly announced it had to halt redemptions and wind itself down.
Although Third Avenue’s “Focused Credit Fund” was an
outlier due to the sheer junkiness of its portfolio, its collapse exacerbated concerns over two of the dominant market trends of the past half-decade: massive retail money inflows into corporate bond funds; and the mounting difficulty of trading bonds they hold. Together, they could spell trouble.
The Office of Financial Research, a body set up inside the US Treasury in the wake of the financial crisis to monitor and analyse dangers in the financial system, highlighted the FCF debacle as an illustration of “the risks of liquidity mismatch in some mutual funds” in its first
annual financial stability report.
“The combination of
weak fundamentals and reaching for yield in recent market conditions makes a recurrence of such events likely,” the OFR warned.
Across the Atlantic, the
Bank of England struck the same cautionary note in its own semi-annual financial stability report earlier this month.
“The potential risks to financial stability connected with investment funds’ activities relate to their prospective impact on markets, particularly where they offer short-term redemptions to investors while investing in longer-dated and potentially illiquid assets,” the UK central bank said.
Are the worries justified?
Market liquidity is tricky to define, but the simplest way of describing it is the ability to trade a security quickly, smoothly and without moving the price too much. Traders say this has atrophied across most markets in recent years, but as the charts from Citi (below) show, headline trading volumes look healthy across asset classes.
Furthermore, the difference between the price investors are willing to buy or sell a security — a popular gauge of liquidity — also looks robust. These three charts from Deutsche Bank, JPMorgan and Citi that show the “bid-offer” spreads for investment-grade and high yield corporate debt,
Treasury bonds and equities respectively.
However, these charts do not account for the fact that the size of markets has expanded significantly since the financial crisis, and do not reflect important market structure shifts. Average bid-offer spreads do show how hard it can be to trade when markets are choppy.
Corporate bonds are the epicentre of bond market liquidity concerns. While even Treasury bond turnover is down, fund managers complain that “credit” is the hardest to trade these days. If you adjust the trading volumes for the market size a bleaker picture of liquidity emerges, as the charts from JPMorgan and Deutsche Bank show.
Part of the problem is banks being forced to trim their corporate bond market trading operations by regulations and shareholder pressure to curtail risks. Banks have now closed once-sprawling “proprietary” trading desks and retrenched their market-making operations. The cuts have been particularly ferocious in corporate bonds. Wall Street’s portfolio of investment grade corporate bonds even
briefly turned negative earlier this year.
Concerns have been exacerbated by the widening “liquidity mismatch” at the heart of the market. Mutual funds have become increasingly important players in corporate bonds, but their money comes from retail investors who can pull out whenever they want, even though the underlying securities their funds buy are increasingly illiquid. The
FCF failure is a good example of what can happen when a mutual fund with illiquid holdings is hit by big investor withdrawals.
Citi’s chart below shows how the mutual fund complex has expanded in recent years.
The upswing in mutual fund ownership of the US corporate bond market has been particularly sharp. Retail investors, burnt by two savage equity market drops in less than a decade, have recoiled from stocks and ploughed billions of dollars into debt issued by US companies.
Not only does the rise of mutual fund and exchange traded funds hurt trading — they tend to buy and sell less frequently than banks used to — they also exacerbate the widening divergence between the stability of money in the market and its tradeability.
“These funds may not be able to liquidate their investments as quickly as their shareholders can withdraw capital, presenting redemption risk for the funds and fire-sale risk for the markets in which they participate,” the OFR said.
To the left is a chart from the New York Fed showing how mutual fund ownership of corporate bonds has as a result ramped up dramatically since the crisis. They now hold over 20 per cent of the entire market.
But retail investors piling into corporate debt have also helped encourage executives to take advantage of their largesse. US companies have been
gorging on cheap debt lately, spending the proceeds on an acquisition spree and buying back their own shares.
The result is a record pile of corporate bonds. As a percentage of US gross domestic product, corporate indebtedness is now approaching the pre-financial crisis peak, the OFR noted (see chart to the left).
Many analysts are now worried that the “credit cycle” — as they call the well-established boom-to-bust lifespan pattern of corporate debt — is now approaching the inevitable, painful denouement.
Although the pain is most apparent in the energy sector, the fallout is spreading as the Federal Reserve looks to tighten interest rates further during 2016. UBS recently estimated that as much as $1tn of US corporate debt could be in the danger zone as interest rates rise in the coming years.
Below is a visual representation of the credit cycle, again courtesy of the OFR. The body’s analysts reckon that the US is closer to the downturn stage than any other major region.
The New York Federal Reserve argued in a series of research articles this year that concerns over bond market liquidity were overwrought, even in corporate debt.
In one
post the central bank branch’s researchers aimed squarely at quelling fears over the rising role played by mutual funds and the declining part played by bank dealing desks, and highlighting how investor flows into bond funds were as stable as in the past (see the chart below to the right).
The NY Fed therefore concluded: “Even if we do observe large mutual fund redemptions in the future, our evidence does not suggest that reduced dealer positions will exacerbate the effects on corporate bond pricing and liquidity.”
Yet tellingly other regulatory bodies are less sanguine. The FCF failure might be a one-off blip, but the issues it highlighted are not going to go away.
“The recent rapid growth in open-ended funds, and their continued investment in less liquid assets, has reinforced the risk that large-scale investor redemptions could result in sales of assets by funds that might test markets’ ability to absorb them,” the Bank of England said in its stability report.
“The risk is that this could impair market liquidity, which is already fragile, particularly in markets that are important for extending funding to the real economy.”
