How Bad Regulations Drain Bond Liquidity

May 19, 2015

Jared Dillian is the editor and publisher of The Daily Dirtnap, a market newsletter for investment professionals, and the author of “Street Freak: Money and Madness at Lehman Brothers.”


Perhaps you saw the news that ETF issuers were beefing up lines of credit, in case they need cash to meet redemptions.


But why do they need cash to meet redemptions? You can sell the stocks (or bonds) and turn them into cash.


It’s not quite that simple anymore …


How It Works

But it’s not just ETFs. It’s open-end mutual funds, too. In fact, the open-end funds are the primary concern.


Say you’re a shareholder in the Vanguard Long Term Corporate Bond Fund. If you have ever worked in capital markets, you know that many long-term corporate bonds are not all that liquid.


Pretend you’re a large shareholder in the fund, say, at $2 million. One afternoon, you decide to redeem all of your shares. You’re going to get it done at the net asset value (NAV) and it’s the portfolio manager’s job to sell securities to raise cash to meet the redemption order.


If those bonds are sold at prices that are lower than when they were last marked, the mutual fund company loses money—or, put another way, these transactions costs are incurred in the course of regular business and are covered by the fund’s expense ratio.


This gives some people the illusion of infinite liquidity. I can buy or sell mutual fund shares at one price, unlimited size—even though the underlying asset may not be liquid at all.


One Fed official remarked that open-end mutual funds (and ETFs) are a “liquid claim on illiquid assets.” This was about the time that the Fed proposed an exit tax on mutual funds.


But why is this an issue now? Liquidity never used to be a problem before, right?


When Liquidity Was Abundant

Back when I worked in the markets, the bond market was so liquid that a corporate bond trader could offer you a half-point-wide market on $25 million of just about any issue. Now, they’ll show you a two-point-wide market on $2 million—and then move the market on you.


People who understand today’s bond market will tell you that liquidity is nonexistent. And they can tell you exactly why:


  1. The Volcker rule
  2. Capital constraints caused by things like Basel III


It just isn’t profitable to make markets in bonds (or just about anything) anymore.


The Volcker rule has hit bond desks particularly hard. There are tens of thousands of bond issues, and if a customer hits you on $10 million of XYZ bond, you may have difficulty locating $10 million of XYZ bond to sell.


The Volcker rule is interpreted quite broadly, so if you sell ABC bond instead as a hedge, this is viewed as proprietary trading. So traders pretty much go to work and just sit there.


To make matters worse, the bond market is many, many times bigger, as we’re running about $2 trillion of corporate issuance a year, without even considering the government/sovereign paper.


What we have is a very crowded theater with a very tiny exit:


Source: Financial Sense



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