United States

No market for young traders: Get ready for your grandparents' bond market


A lack of liquidity in fixed income will create opportunities for long-term investments in the middle market.

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During the past 40 years financial markets in general, and the fixed income market in particular, profited from a preferred place in the national policy matrix. The cumulative impact of Dodd-Frank legislation, reduced leverage ratios, and the Federal Reserve’s intent to suppress the shadow banking system has brought that to an end. As a result, it shouldn’t be a surprise that a combination of regulatory changes and the unwillingness on the part of large banks to take on interest rate risk associated with fixed income transactions is causing a serious lack of liquidity in the bond market. This illiquidity problem, and policymakers’ unwillingness to address it, may foreshadow what’s to come for Wall Street.

Given the strong probability that the U.S. faces a period of slow growth, low rates and low inflation, the fixed income market will begin to look a lot like it did in the 1950s when the nominal returns on fixed income were essentially flat and real returns negative. In other words, Washington’s lack of concern is a signal to Wall Streeters that they should prepare to exist in what will approximate their grandfather’s fixed income market.

Under such conditions, portfolio managers and investors should anticipate policymakers using financial repression to damp down financial innovation with the intent of reallocating capital away from speculative activity and toward medium- and longer-term uses in the productive and services sectors. That, over time, will boost productivity and growth while altering the balance of power within the U.S. political economy, ushering in an era of change on Wall Street that will likely impact head counts and quite possibly the organizations of the large systemically risky banks themselves. Most importantly, it reintroduces the idea of relationships as the center of banking, supplanting the current high-frequency trading model where volume triumphs. 

Liquidity, the lifeblood of the market, is comprised of two distinct components. The first component is the one investors typically think of—the ability to buy and sell large amounts of assets without moving the market. The second component is the ability to accurately price assets. They are similar, but different in form and function with price discovery the most important in function.

MIDDLE MARKET INSIGHT: Today, the “smart money” is pursuing alternative strategies that involve longer-term investment in the real economy and, importantly, in the middle-market firms that populate it.

In January 2013, approximately 0.6 percent of bonds in the Financial Industry Regulatory Authority (FINRA) – BLP Active High Yield U.S. Corporate Bond index changed hands on a daily basis, a volume that holds today. On a typical day, 99 percent of the high yield corporate bond market does not trade. Under such conditions a 1 percent turnover evenly distributed presents little concern. However, the volume of outright primary dealer transactions stands near post-crisis lows and has declined noticeably relative to the total stock of U.S. debt held by the public. Both are telltale signs of growing illiquidity in these markets.

The problem is that many bonds don’t trade at all on any given day; volumes are concentrated in a few select issuers, or even specific bonds. Many bonds go without a single trade on any given day.  Sometimes that behavior can extend for multiple days. As a result, market makers are overly-dependent on “matrix” pricing where price is not based on an actual trade, but on guesstimates of where the bond should trade based on similar bonds—which themselves, may or may not have traded.

Primary dealer outright transactions stand near post-crisis low

Source: RSM, New York Fed

As investor uncertainty about price increases, neither potential buyers nor sellers want to transact. With neither side convinced that the price is “fair,” the impact of asymmetric information rises, causing both parties to withdraw and making it difficult to complete transactions.

Consequently, a lack of price discovery and illiquidity leads to reduced trading, which in turn decreases the rate of risk transference and makes it difficult for equilibrium pricing to be reached. When regulatory oversight increases, incentives to buy and hold, which reduce volatility, are an implicit policy objective. Capital rules today, altered on the margin, have incentivized the large banks to move assets from trading books back into hold-to-maturity books. Under such conditions, hedging receives unfavorable treatment and policymakers obtain a modest de-financialization of the economy.  

We are already seeing a change in behavior among large institutional money managers to this new policy framework. Today, the “smart money” is pursing alternative strategies that involve longer-term investment in the real economy and, importantly, in the middle-market firms that populate it. This is aligned with anecdotal evidence heard from clients that have been surprised at the attention and focus they have recently received from what is left of old Wall Street after such a long period of neglect. Those firms that represent the heart and soul of the real economy should take advantage of this newfound attention and consider pursuing growth and expansion opportunities. While this internal financial rebalancing will not proceed in a linear fashion, it bodes well for the non-financial portion of the economy that is increasingly moving toward the center of the economic policymaking framework in Washington.

The hedge fund model that supported outsized returns for the big banks has exhausted itself. The trader-brokerage model is in a period of transition and it’s not certain what will follow in its place. In some respects this will require financial institutions to re-establish relationship banking at the core of their operations, augmenting the risky high-frequency trading model that is coming under increased regulatory scrutiny.

From the point of view of regulators, this will likely be interpreted as a policy success. While there are short-term risks that an adverse shock in fixed income markets will take place as the Fed begins to normalize policy, one that could very well affect the real economy that this new policy framework intends to support, efforts to make sure that financial institutions and shadow finance never again put the economy in jeopardy from excessive risk-taking with taxpayer insured capital are moving forward.  


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