The Mysterious Evaporating Bond Liquidity?

Every so often, pundits get in a lather over some arcane technical issue they are just sure will roil markets sometime in the future if it isn't fixed right now! In the late 1990s, it was Y2K. Today it is allegedly low liquidity in bond markets, which luminaries from bankers to economists to fund managers and the IMF warn could cause big problems the next time investors rush to sell in a crisis. And, well, not to be Pollyanna, but this all smacks of Y2K for bond markets. We don't see much evidence bond markets have broken down.

The fears rest on factoids like the $1 trillion fall in traditional market makers' (banks and dealers) inventories since 2007, a fall in market depth (the average of the best three buy and sell offers), the vast amount of US Treasurys locked up on the Fed's and banks' balance sheets, and stricter regulatory requirements as evidence bond markets have dried up, making prices subject to sharp swings. Their sole piece of evidence this is actually an issue is the so-called US Treasury "flash crash " of October 15, 2014, when 10-Year Treasury yields fell from 2.19% to 1.86%, then jumped to 2.13%-in mere minutes.[i] That the move was preceded by abnormally low bond liquidity, pundits argue, shows bond markets are extra vulnerable.

In Tuesday's New York Times, Peter Eavis provides an excellent summary of the feared implications, their inherent misperceptions and some insightful counterpoints to all those warning of bond bloodbaths. As he writes:

Those voicing such fears say that recent changes in the bond market could change the way that Wall Street banks, large bond funds and trading systems would behave in a period of turbulence. Other developments have left the market vulnerable, they say. A huge rally in bond prices over the last several years, stoked by vast amounts of monetary stimulus by central banks, may have made the market vulnerable to a sharp sell-off.

Also, more bonds are now concentrated in the hands of a few large fund management companies, whose combined selling could tip bond prices into a tailspin. And then there is the role of electronic trading, which has spread in certain bond markets and is thought to have played in the disruption in the Treasury market in October.

According to the pundits warning about all this, the trauma could play out on two fronts. Bond funds could have a more difficult time meeting redemptions if their fund holders panic in a crisis, forcing managers to liquidate large blocks of bonds at a time-theoretically driving prices down, lowering the fund's net asset value and triggering a vicious circle. One might expect market-makers to step in and soak up the excess supply, but as Eavis explains, "the new rules, the worriers contend, have eaten away at the bond market in other ways. The regulations, they assert, have caused Wall Street dealers to slash the stockpiles of bonds that they make available to investors. As a result, they assert, the dealers will be less willing to act as 'shock absorbers' in future market turbulence and buy bonds from fleeing investors." An added fear surrounds bank balance sheets, which many argue are more exposed to Treasury volatility than ever thanks to the Basel III capital rules (particularly the 7% minimum tier 1 ratio, which phases in fully in 2019, and the Liquidity Coverage Ratio, which orders banks to hold 30 days' worth of projected cash flow in Treasurys or other "high quality liquid assets"), potentially incentivizing them to dump bonds in a crisis to shore up capital.

Now, we get why this all sounds plausible, but it ignores a wealth of counterpoints. Like the fact investors tend NOT to dump bonds in a financial crisis-US Treasurys often benefit from a "flight to safety" mentality. And the whole "dealers won't step in" issue appears to be a straw man. We'll let Eavis speak for himself:

It is not clear that the dealers ever acted in this way, however. If anything, there is evidence for the opposite.

Trading dried up for a time during the shakeouts in the market in 1994, 1998 and 2008, all of which occurred when there were far fewer restrictions on Wall Street dealers. In 1994, for instance, when interest rates unexpectedly rose, bond dealers slashed their holdings of bonds by nearly a third, according to figures from the Federal Reserve.

"The dealers are profit motivated, so they are not going to catch a falling knife," said Marcus Stanley, policy director at Americans for Financial Reform, a group that supports rules that rein in risk taking on Wall Street.

Echoing their past behavior, the dealers reduced their inventories in the so-called taper tantrum, a sell-off that took place in 2013 after investors concluded that the Fed might "taper" its monetary stimulus earlier than they had thought. Analysts at the Federal Reserve Bank of New York concluded later that regulatory constraints - like higher capital requirements - were most likely not the cause. Banks that had spare capital to take on more bonds chose not to use it, and withdrew. As a result, the Fed's researchers said, the dealers most likely pulled back as part of a marketwide shift in which bond investors became more cautious about the outlook for bond prices.

To this excellent analysis, we'd merely add a few points.

One, markets-stock, bond or otherwise-have never needed official market makers to stop the bleeding in a crisis. In all the panics of the last 200-plus years, it has always been gutsy individual or institutional investors who have had the fortitude to "buy when there is blood in the streets." Think Nathan Rothschild in the Napoleonic Wars. Hetty Green in the 19^th and early 20^th centuries. Warren Buffett in 2008. The many unknown folks who had the same mentality, iron stomach and long-term belief in markets and capitalism. Markets are built on the trading decisions of millions upon millions of people.

Two, the big fear assumes none of the factors allegedly reducing liquidity will change-that all else will always be equal. But this is a fallacy. The Fed could decide to stop rolling over maturing bonds, keeping more Treasurys on the open market. Total Treasury supply could rise faster if the deficit ticks up. Regulators could further loosen the market-making exemptions to the Volcker Rule, granting banks more flexibility. Market structure could change, with new outfits replacing banks and traditional broker dealers as primary market makers-liquidity abhors a vacuum. Electronic trading firms have already begun stepping in, and there is talk of establishing bond exchanges. All would increase liquidity.

Three, markets are efficient. The more widely a fear is discussed, the less likely it is to pack a wallop. Not only do markets have the chance to discount it, but they have the chance to adapt. For example, investors are changing the way they trade to try and increase liquidity, breaking big trades up into smaller batches to prevent big price movements. Funds are also holding more cash to meet redemptions pre-emptively, rather than waiting to sell assets to raise cash when the request hits. Banks are also changing how they account for bonds on their balance sheets in case interest rates suddenly spike, marking more of them as "held to maturity," removing the need to mark them to market. So if bond prices fall, there isn't much need to sell purely to maintain capital ratios.

Some question whether this cripples banks in a crisis, making it harder for them to raise cash if needed, but the accounting change doesn't prevent banks from selling bonds. They do it all the time-the "available for sale" designation, which requires mark to market, simply means banks plan to sell the securities in the near future. Note, many bonds held for LCR purposes are marked "held to maturity" for this very reason-if they were "available for sale," banks would be expected to sell in the next few months or so, which would largely defeat the purpose.

Given how far and wide folks have feared and discussed bond liquidity for the last couple years, we have a hard time seeing liquidity issues sneaking up on anyone when things get rocky. More likely, it ends up being a Y2K-style load of "is that all it was ??" We've already seen evidence: German bonds. On April 29, German bond values lost a total of $61 billion in one day-roughly 5% of the German bund market's total value. 10-year yields shot from 0.16% to 0.26%. It was just normal volatility, but exactly the sort of big price movement many fear will drive a rush of unfillable sell orders. And yet there is no evidence investors had a hard time selling German bonds if they needed to-nor did any of what happened in the bund market infect markets elsewhere. Folks largely kept calm and carried on.

So while pundits may continue to fret bond illiquidity, we'd encourage folks to trust the market on this one. It's already adapting, just as it has for centuries, making things highly unlikely to play out as pundits warn.