[This article previously appeared on our sister site, IndexUniverse.eu.]
Two charts in a recent presentation by Citi's credit product strategist, Matt King, tell the story of a structural fault line in the financial markets.
King illustrates how the assets of US mutual funds invested in investment grade and high-yield debt have trebled since 2008, from $300 to $900 billion, reflecting investors' increasingly desperate search for interest income in low-rate environment.
But the infrastructure supporting bond trading has weakened. The banks that act as intermediaries between the bond market's buyers and sellers have seen their holdings drop from $286 billion to $69 billion—by 76 percent—to levels last seen in 2002.
And King reminds us that bond prices are much more prone to jumps and "cliff effects" than share prices: as an example, note the 2006-08 behaviour of Lehman Brothers' equity and of the company's 2016 euro-denominated bond (illustrated in the chart below).
Lehman's share price declined steadily over the two-year period leading up to the company's insolvency as investors factored in its deteriorating prospects: but Lehman bondholders didn't face up to the worst until right at the end, at which point bond prices went from 70 to near-zero in an instant.
This kind of behaviour places an automatic strain on the relationship between bond funds—which promise instant liquidity and continuous pricing—and the underlying bond asset class.
Meanwhile, the underlying liquidity of the bond market has deteriorated since Lehman went bust. Efforts at forcing bond trading into a central, exchange-like format haven't worked. The market still relies on a dealer-centric, capital-intensive transaction model. And the dealers' capacity to hold bonds has been steadily eroded since 2008 due to restrictions on proprietary trading and higher regulatory charges for inventory.
When an asset manager wants to buy or sell bonds he typically asks several dealers via a so-called request-for-quote (RFQ) process. Dealers and clients are aware of each other's identity all the way from the initial request through to post-trade clearing and settlement.
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