FIVE SECULAR CHANGES
Lack of Market-Making and Regulatory Changes That Will Impede Price Discovery in the Next Downturn
Fixed income instruments that trade OTC are complex and already illiquid. Fixed income markets, unlike their counterparts, the more liquid stock markets, are characterized by having the majority of their trades executed OTC. Similar to stocks, once a bond is issued in the primary market, investors can, in theory, trade the bonds in the secondary market. However, although secondary market trading for stocks occurs on popular lit exchanges such NYSE, Nasdaq, and AMEX, there are currently no significant lit exchanges for fixed income securities. Some participants have packaged fixed income securities into ETFs and these ETFs trade on lit exchanges.2
Wrapping fixed income securities into ETFs does not solve the problem of the lack of exchange-traded markets for fixed income securities. It only hides the lack of liquidity of the underlying constituents. These underlying securities, troublingly, do not trade on any major liquid exchange.
OTC bond market-makers are dealers who stand ready to make markets even in periods of market crisis. Since the 2008 financial crisis, the bank-affiliated dealers are buying fewer corporate loans and bonds for their own accounts. It is estimated that inventories of corporate bonds held by dealers declined from $29.2 billion at the end of 2013 to $14.2 billion at the end of 2018 (Kaplan 2019). Further, it is likely that even this lower level of inventory is comprised of much higher-grade securities than before the 2008 crisis. For example, in a study of about 56,000 infrequently traded corporate bonds, Goldstein and Hotchkiss found that dealers have shorter holding periods for riskier and more illiquid securities (Goldstein and Hotchkiss 2018).
Since April 2013, the Federal Reserve Bank of New York has been tracking the level of inventories of primary dealers in corporate bonds. The data contains a breakdown of investment-grade and below-investment-grade bonds, which was not available prior to April 2013 when only the aggregate-level data was available. The graph in Exhibit 1 shows the weekly changes in inventories for both investment-grade and below-investment-grade corporate bonds using primary dealer statistics data obtained from the Federal Reserve Bank of New York database (Federal Reserve Bank 2019). One can clearly see a general downtrend in inventory levels for all bonds. More precisely, the graph shows that from April 2013 to the end of 2018, investment-grade bonds in primary dealer inventory decreased from approximately $14 billion to $5 billion; the inventory level for bonds below investment grade decreased from $7 billion to $2 billion.
When an extreme crisis hits, historically, OTC market liquidity disappears. That is, no one is available to take the other side of the trade. There are simply no bids, no offers, and no trading activity in OTC markets. The recent reduction in dealer inventories means that markets will be even more volatile in the next crisis.
Primary Dealer Inventory
Lack of liquidity impedes bond price discovery in a crisis. Several features affect the pricing of bonds, such as the yield to maturity, the credit quality, and macro cycles. Some academics have shown empirically that the pricing relationship of bonds is driven by credit quality and liquidity. Friewald et al. (2012) examined over 20,000 corporate bonds available from the Trade Reporting and Compliance Engine (TRACE) over the period from October 2004 to April 2008, including two crises, the GM/Ford crisis in mid-2007 and the sub-prime crisis starting in mid-2007 (Friewald et al. 2012). They discovered that transaction costs greatly increase in periods of crisis, indicating severe illiquidity in the market. They also found that liquidity explains about one-third of the yield spread variation in general, with higher explanatory power during crises. This highlights the importance of transparency of trades in the bond market, which otherwise will impede price discovery when liquidity inevitably decreases in periods of crisis.
Although stock risks are identified by well-known factors such as value/growth, momentum, earnings quality, and size, bonds are more difficult to characterize by factors.3 Cochrane’s (2011) factor-zoo does not currently exist for bond markets, and the bond markets have yet to witness the same explosion in growth of smart-beta equity products. The bottom line is that bonds are very distinct in their risk, behavior, and trading characteristics, compared to stocks.
One particular feature of the fixed income market is the complexity of all the instruments traded in that market, which include bank debt, ABS, and mortgages. First, unlike the stock market, each individual issuer may have many different outstanding securities represented. Therefore, for one single issuer, we may have a heterogeneous collection of illiquid or thinly traded securities (see Fender and Lewrick 2015). The second layer of complexity in the fixed income market is deeper and multifaceted. It involves all the credit derivatives and the entire securitization market (the existing securities of which are constantly being repackaged into still more securities)4 that has allowed participants to have access to a wide range of investment opportunities without necessarily grasping the full consequences of their investments during economic downturns.
Given the bond market’s complexity and the lack of liquid exchange-traded markets for most bonds, the majority of the trading activity occurs with counter-parties in the OTC market to gain better control of fixed income risk exposure. According to Duffie (2012), “The OTC market covers essentially all trades in bonds (corporate, municipal, U.S. government, and foreign sovereign bonds), loans, mortgage related securities” (7). The fact that fixed income securities are mainly traded in the OTC market has three major consequences:
- It is difficult to get a sense of the true liquidity of the market and to quantify it properly. This is directly related to the opaque nature of the OTC market and the lack of data. In comparison, in an equity exchange-traded market, one has access to intraday and daily price data and can measure the trading activity, thanks to the availability of the bid and ask quotes, traded prices, and volume. In the OTC market, to the best of our knowledge, there is very limited access to bid and ask quote data and questionable volume data. One can only get access to the buy and sell data through proprietary databases that are difficult to access and process. Although the TRACE database through FINRA exists and provides secondary trade prices, the ability to access this data is cumbersome enough to effectively render it difficult to employ. The natural consequence, therefore, is that bonds are less liquid and less understood.
- The lack of liquidity can be amplified by the fact that there are fewer diverse participants in bond markets. In the equity market, although retail investors have smaller account sizes than that of institutional investors, the amount held by retail investors is very large. In the bond market, there is very limited active retail trading activity.
- Given that the trading happens in a closed loop among relatively few institutional entities, bad news can impact liquidity dramatically due to feedback effects. The example of Lehman Brothers is illustrative of this effect during the crisis. Although there are discrepancies regarding the precise catalyst of the credit crisis of 2008, many believe that the crisis began with Lehman Brothers’ sudden inability to secure short-term borrowing from other counterparties. Why would other counterparties, who have been faithfully doing business with Lehman for years, suddenly stop lending to Lehman?
In their book, Animal Spirits, Akerlof and Shiller (2009) argued that the cornerstone of any business transaction is trust. As soon as the Street learned about Lehman’s large book in MBS, they were terrified of the exposure to credit risk that Lehman posed and ceased doing business with them. The fear was viral; as soon as the first counterparty declined to transact business with Lehman, all other counterparties turned their backs on Lehman. A crisis of confidence is essentially a feedback loop of fear that propagates through the whole market.
Volcker rule further limits proprietary trading. Another important regulatory change affecting the corporate bond market is the Volcker Rule. The intent of the Volcker Rule is to prohibit banking entities with access to the discount window at the Federal Reserve or to FDIC insurance from engaging in risky proprietary trading. It seeks to limit risks in proprietary trading that could lead to an increase in the risk a single institution poses to their entire financial system. After a “laborious process,” the Volcker Rule became effective in 2014 and applied to banks with trading assets in excess of $50 billion.
Compliance with the rule was required by July 21, 2015.One of the main issues in the Volcker Rule is the ambiguity in precisely defining the rules for market-making in the broker-dealer business of banks (see Bao et al. 2016). The Volcker Rule set guidelines to separate market-making from proprietary trading because market-making should have rapid inventory turnover with the vast majority of profits sourced from bid-ask spreads rather than from inventory appreciation.
The problem in following the guidelines set in the Volcker Rule lies in the inherent difficulty in distinguishing market-making activity from proprietary trading. This ambiguity in the guidelines may motivate dealers to choose more conservative trading strategies. New rules favoring customer-facing trades may discourage dealers from using the interdealer market, and inventory-based metrics may lead dealers to reduce their inventory exposure. For example, Bessembinder et al. (2018) showed that the inventories in corporate bonds for bank-dealers have decreased continuously since 2006 and more significantly after the implementation of the Volcker Rule.
Additionally, metrics such as inventory turnover or inventory aging, which are used to analyze stocks, cannot be applied in the same way to corporate bonds. Duffie (2012) noted that the average half-life order imbalance in investment-grade corporate bonds is two weeks, whereas it is about three days for stocks. The average half-life order imbalance allows one to have a measure of the time required to revert to an acceptable inventory target level. Although this figure is an average, it is reasonable to believe that it could change significantly in periods of crisis as liquidity disappears. The difficulty in measuring and monitoring such metrics for the successful implementation of the Volcker rule is yet another factor giving rise to complexity encountered with measuring liquidity risks in bond markets.
OTC market making is nearly impossible unless there is a matched book. Furthermore, the requirement particularly affects liquidity in times of market stress. Bao et al. (2016) showed that liquidity decreases especially during a market crisis, ironically when liquidity is needed the most and the willingness to trade in corporate bonds is high. Ultimately, market makers must take a view to participate, accelerating what would then be a slippery slope into proprietary trading. With opaque, and therefore wide, bid-ask quotes in these markets, it is almost impossible to have a matched book for market makers.
Large asset managers’ claim that they “will be the market” is preposterous. Some large asset management companies have publicly stated that they would stand ready to be the market in times of market crises to allay the fears of investors. A study by Fitch found that some asset managers are already holding higher portfolio cash balances to meet investor redemptions upon demand, in effect trying to offset structural declines in dealer inventories and market liquidity by holding additional internal liquidity through cash (Layvand and Noll 2014). Although cash could be used to satisfy margin calls and give borrowers more assurance, this type of liquidity actually leads to a false confidence because cash liquidity does not always translate into trading liquidity. Trading liquidity provides a mechanism to exit a given position. The ability to unwind a position is paramount, especially during a financial crisis. It is also important to note that many bond mandates require minimizing cash.
A study by Alliance Bernstein on bond market liquidity found that when the system was tested by a period of prolonged selling during the so-called taper tantrum of 2013, bid-ask spreads widened sharply (Peebles and Shah 2016). This indicates that in periods of stress, it is unclear whether asset managers can provide the liquidity that is needed. As of December 2018, fixed income hedge funds held a total of $556 billion in assets under management (Barclay 2019), corresponding to just 6 percent of the $9.2 trillion corporate bond market.5 Given their relatively small size, it is simply impossible for hedge funds to become the market and absorb large liquidity shocks.
Furthermore, fixed income hedge funds tend to hold large long positions, which means that when prices fall, the net asset value (NAV) of these funds decreases significantly. This puts them in an unlikely, if not impossible, position to be the market. It would be imprudent, therefore, to look solely to larger asset management companies to provide liquidity in OTC markets when a financial crisis occurs.
2 We acknowledge trading in bonds does occur on the NYSE, however, without the loss of generality we assume that most bonds trade OTC. Lit exchanges are those that allow the order book to be publicly available to all the participants on the exchange.
3 Common equity factors have been made popular by Fam and French (1993, 2008, 2015) as well as many other academics who have documented that equity markets price more than just the CAPM’s beta of Sharpe (1964) and Lintner (1965), as well as multi-factor model extensions such as APT by Ross (1976).
4 This occurs as securities are repackaged, causing still more securitizations, or “re-securitizations,” as well as through the combination of re-securitization and credit derivatives.