The predictability and smooth-functioning of bond performance during the recent, protracted period of low interest rates has led to record corporate bond issuance.
Investors seeking a safe place for their assets have moved into bond markets. And there has been no shortage of bonds to buy. But these “safe investments” that have provided protection from a volatile stock market can themselves become traps without thoughtful consideration of rebalancing and exit plan strategies.
Reduced Dealer Inventories Impact on Bond Market Liquidity
Most previously issued bonds are traded over-the-counter, rather than in a centralized exchange. Historically, over-the-counter transactions have been facilitated by bond dealers who matched buyers to sellers. These dealers held their own inventory of bonds which they could access in the absence of an immediate match.
But increased regulation and decreased risk appetite have drastically reduced dealer inventories. Traditional channels for bond sales are running at a fraction of their historical capacity which is fueling a growing concern about the market’s underlying liquidity. In the event that a large number of investors attempt to sell their bond holdings at the same time, the lack of supplementary buying sources could trigger large markdowns in the value of the holdings of bond market participants.
At the close of 2016, total outstanding US bond market debt was just under $40 trillion (SIFMA), more than twice the size of US equity markets. This amount outstanding has more than doubled in the last 15 years, buoyed by the secular decline in interest rates.
Coincident with this growth, investor interest in the bond market has increased. According to Morningstar, over $3.1 trillion is allocated to US Fixed Income mutual funds and exchange-traded funds (ETFs) as of 12/31/2016.
Total Outstanding US Debt ($Billions)
Unlike the equity markets, with their central exchange, bonds typically trade over-the-counter. A given issuer may have any number of bonds outstanding with different tenures, coupons, embedded options, and more. (Take, for example, GE which has one stock but more than 1,000 types of bonds with different yields, maturities, and currency denominations.)[i]
A centralized bond exchange, if it existed, would have to accommodate that great diversity of issuances, making it several orders of magnitude greater than the stock market.
Historically, buyers and sellers have been matched up by intermediaries, most frequently bond dealers. These dealers traditionally held their own proprietary inventories as well, both to speculate with proprietary capital and to facilitate transactions between buyers and sellers without an immediate marketplace match. Even as the market as a whole has expanded recently, due in part to increasing regulation and decreased risk appetite, bond dealer inventories have shrunk.
Primary Dealer Corporate Bond Inventories ($Billion)
Source: Federal Reserve Bank of New York
For the time being, investor demand has been satisfied by record issuance from companies looking to take full advantage of a low-interest-rate environment. As money has flowed into the bond market, it has found a profusion of opportunities awaiting its deployment.
Corporate Bond Issuance ($Billion)
The Future of Corporate Bond Liquidity
But what should we expect if investor sentiment changes and dollar flows into bonds reverse course?
Counterparties who in the past would have been willing to facilitate sales and provide liquidity at a marginal cost, have scaled back their activities dramatically.
Should investors flood the market with requests to sell into a dearth of natural buyers, we could reasonably expect bond prices to fall. If the market imbalance is large, the bond price declines could be significant, affecting both the sellers paying for liquidity, and the long-term holders watching as the value of the bonds in their portfolio drop with each decline in price.
Bonds have long been championed as a relatively safe alternative to equities given their low historic volatility and diversification properties, but bonds carry their own unique risks. Investors may have entered the market through wide doors, but if there is a rush to sell, they may be surprised to find that many of the exits may become “locked” in front of them.
Does this mean investors should run to the exits now?
The position of Highland remains consistent: a clear understanding of your investment objectives, whether to mitigate stock market volatility, stabilize income streams, or to diversify a portfolio, coupled with an impartial market analysis can equip investors with an optimal strategy for success.
And that strategy could require the rebalancing of a portfolio—and the possibility of a more graceful exit.