While the gold, oil, grain and other commodity markets try to recover from the beatings experienced over recent days, the US Securities and Exchange Commission (SEC) is turning its attention towards the health and transparency of the corporate bond market with an all-day roundtable addressing the market’s transparency and market structure today, 16 April.
Although regulatory officials state the round table will examine “how best to improve transparency, efficiency and fairness of the fixed income markets,” many industry insiders expect it to address the drama associated with of the ending of the US Federal Reserve’s quantitative easing (QE) policy before it becomes a crisis.
The Federal Reserve’s introduction of QE policy has distorted the corporate bond market explains William Rhode, principal and director of fixed income at industry research firm Tabb Group. “It has left the market with a major structural issue that does not have a ‘silver bullet’ solution.”
Before its started in December 2008, broker-dealers created a market structure that facilitated the distribution of corporate debt, provided the pricing for the industry and contributed the necessary liquidity for large institutional block trades, he adds. “There has been very little change in the market structure until now.”
The corporate bond market began to fragment with the introduction of multiple electronic price-aggregation and trading venues, such as MarketAxess, Bloomberg, BondDesk and Bonds.com, which improved price transparency while compressing quote spreads.
The push of global regulators to have broker-dealers reduce their capital leverage from 40:1 or 30:1 to that of 12:1 or 10:1 has also lead them to reduce their corporate bond inventories to record lows and onto the buy-side’s books.
“It’s not just the secondary liquidity that has moved on to the buy side’s books,” says Rhode. “It’s the glut of primary issuance that we have seen over the past year and a half due to quantitative easing policies.”
As a result, many of the leading asset managers began developing their own crossing networks to help facilitate large institutional block orders that broker-dealers may have helped to transact in the past but now do so less frequently.
In effect, tier-1 asset managers have now taken on the market-making role by providing liquidity to the market as well as taking it, according to Bob Smith, president and CIO of Sage Advisory Services.
UBS was first to offer a crossing network when it launched its Price Improvement Network (PIN) in 2010. Yet, it was not until 2012 that BlackRock, Goldman Sachs, and Morgan Stanley announced their respective Aladdin Trading Networks, GSessions and Bond Pool platforms. Citi, Deutsche Bank and J.P. Morgan also revealed plans to launch similar platforms earlier this year.
These new liquidity venues tend to be open to other asset managers who trade in the same large block sizes and leave smaller institutions without access to the liquidity, explains Smith.
He has seen some days where buying US$30 million of an A-rated industrial-name corporate bond, which could be done on the wire during a decent day, now involves buying US$1 million from the wire and entering an order for the remaining US$29 million over the next four to eight hours.
“It’s not a frequent occurrence,” he says. “But if I’m starting to see it happen, I cannot imagine what is challenging larger institutions.”
The entire corporate bond market is in uncharted waters with the period of lowest interest rates seen in the past 400 years, agrees Rhode.
“We just don’t know if the current market structure has been tested in terms of liquidity constraints on a bad-hair day,” says Smith. “We are living in an era when the Federal Reserve has done its level best to stimulate the wealth effect by dropping interest rates and buying every Treasury and mortgage-backed security on the planet.”
Once that stops, Rhodes hypothesises that most asset managers will reallocate their portfolios to go long in the anticipated rising cash equities and redeem their corporate bond holdings at a loss to finance the reallocation.
According to the latest minutes of the Federal Reserve’s Federal Open Market Committee (FOMC), which the Federal Reserve, officially released on April 10, it will not happen soon.
Until the US unemployment rate falls below 6.5%, which was 7.6% in March 2013, and project long-term interest rates fall within 0.5% of FOMC’s 2% target, the Federal Reserve will continue to buy US$40 billion of agency mortgage-backed securities and US$45 billion of long-term Treasury securities every month while reinvesting principle payments in the same instruments and rolling over maturing Treasury instruments on their maturity.