It’s tougher to trade bonds these days. Liquidity has dried up, the result of reforms that began in the fall-out of the 2008-09 global financial crisis.
The lack of liquidity has expanded spreads and reduced yields on fresh, heavily traded bonds. For the vast mountain of old bonds and small bond issues that seldom trade, the market has become something akin to bespoke tailoring with fitting and fussing for each deal.
Once upon a time, bonds were traded from dealers’ inventory. It was easy to get a price and fast to trade, with a phone call to a few dealers to compare prices. Bonds were not board-priced like stocks – at least, not extensively – but person-to-person pricing methods worked. Dealers got paid for making a market and providing fast trades (“immediacy,” as it’s called).
That’s changed now. The U.S. Volcker Rule, in effect since July 2015, after years of haggling and regulatory delay, means banks can’t use customers’ money to trade for their own accounts. That cuts the funds available for trading. Other rules that are part of Basel III require banks to tie up their own capital if they hold bonds or any other assets as trading inventory. In this market of margins haggled very thin by big institutional customers, banks and non-bank investment dealers have shrivelled their bond trades.
The effect has been to widen spreads. A 2016 survey by Bloomberg LP found that buyers of fresh, so-called “on the run” U.S. 10-year treasuries were paying a 0.22 of a percentage point premium relative to old, “off the run” notes. Not only is this backward, you would expect the less liquid, older, off the run bonds to provide higher potential profits.
However, the spread paid on the new bonds was 1.75 times the spread for the preceding five years, in which the spread was 0.0126 of a percentage point. Based on Bloomberg’s U.S. Government Securities Index, liquidity conditions have deteriorated significantly in the past two years. That’s about when the Volcker Rule went into effect. Legislators wanted banks to become more risk-averse. The banks followed directions. For bond investors, things got harder.
The effect in Canada of the Basel III rules, as well as Volcker spillover from the U.S., has been perverse. Most Canada-based dealers are also the capital markets units of chartered banks.
“There is no problem buying and selling bonds, but the issue is the buy and sell spread,” says Charles Marleau, president and portfolio manager at Palos Management Inc. in Montreal. “Dealers will do shelf inventory for government bonds, but they won’t do it for low-grade junk.”
Put another way, liquidity is drying up and the dealers are choosy about what they hold. Alternatively, they act as marriage brokers, with each bond desk having to find a buyer or seller for a bond defined by maturity, yield, term, rating, duration, etc. Common stock trades, where one company’s shares are identical, are easier.
For big bond investors, the market is not so bad. According to an August 2015 bulletin from Vanguard Investments Canada Inc.: “A high-quality asset with a very certain and defined income stream will always have buyers if those securities are sufficiently cheap.” So, if you have a $200-million order for a highly rated utility bond and you have Vanguard’s muscle, you’ll get a fill order pretty fast.
But if an investor wants to move $50,000 in or out of a B-minus industrial bond and the potential profit on the deal might be a hundred bucks to the trader, it will go on a “best efforts” basis. The dealer may send out quotes stating he’ll pay one price, but, since he is not trading for his own account, it’s just testing the waters.
The bottom line
Investors – and especially institutional investors – are choosing liquidity over yield. According to a June 2016 Bank of Canada report, monthly volume for the five-year benchmark Government of Canada bond increased five times in quantity outstanding in 2010; in 2015, volume increased to more than 10 times the quantity outstanding.
Now, the bottom line. Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto, explains that lack of liquidity has widened spreads: “If I want to sell at a price that clears the bonds, I can get a bid. The dealer will pawn it off to the retail desk, and the broker will find a client who will buy. The price to the buyer may drop enough to raise the yield by 1%, but it will clear.”
An alternative is bond-based ETFs. These ETFs have no liquidity problems, but even 20-basis-point fees eat up yield these days. You can buy convertibles with a way out – through equities.
For the individual investor and advisor, it’s best to stick with big government issues that always have liquidity.
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