A raft of new laws and regulations, including Basel III and the Volcker Rule, which was approved by five federal agencies on December 10, has prompted banks to derisk their operations and raise capital levels by retreating from their central role in bond trading and market making. While this might add to banks’ safety and soundness, it presents problems for the broader financial markets, some argue, including Michael Aronstein, president, chief investment officer and portfolio manager for New York–based Marketfield Asset Management, which oversees $18 billion in assets. “There’s no shock absorber in the whole system anymore,” he laments.
Aronstein is worried about the fallout for mutual funds in a world in which banks are no longer either able or willing to absorb and transfer liquidity risk in the markets. Over recent years some mutual funds, he says, have taken on riskier illiquid assets in a search for higher returns. The same funds still have to be able to provide immediate cash to customers who want to redeem their shares. As a result, whereas the need for market liquidity has risen for bond funds, “the dealer community has quietly prepared itself to do nothing,” he adds. “That’s a very, very bad combination in an asset where you promised people daily access to the money.”
The liquidity mismatch risks banks once held in their portfolios has moved to such buy-side investors as mutual funds and other investment vehicles, Aronstein says, as banks have sold off their inventory. Others share his view. “There have been massive flows into exchange-traded funds in fixed-income assets, including high-yield and emerging-markets bonds,” says Alexander Sedgwick, research director at MarketAxess Corp., which has developed an electronic bond-trading platform.
The MainStay Marketfield Fund (MFPDX), a long-short equity mutual fund Aronstein manages, has had an annualized return of 9.82 percent since its inception in July 2007 through December 6, according to Morningstar. It easily swats away its long-short equity benchmark of annualized returns of 1 percent over the same time period, and handily tops the S&P 500’s 5.76 percent annualized returns. The fund is up 13.71 percent year-to-date as of December 6, compared with 23.43 percent for the S&P 500.
The data on bond issuance, bond inventory and bond trading spotlight the concerns Aronstein raises. As banks have reduced their role in the bond market, the overall volume of bond issuance has soared. Since the end of 2008, governments, agencies and corporations have issued $26.6 trillion globally in new bonds through December 3, according to Thomson Reuters. At the same time, banks have sharply trimmed their bond holdings, according to data collected by the Federal Reserve Bank of New York. Primary dealer inventories of U.S. corporate bonds, for example, dwindled from $213.8 billion on October 15, 2008, to $66.1 billion as of November 18.
There is also a decline in trading activity at banks. The 12-month rolling turnover of U.S. high-grade bonds was 96 percent in April 2010. It has since fallen to the low–70 percent range, according to Trade Reporting and Compliance Engine, or Trace, data. “That’s below the average turnover rate of 74 percent in October 2008,” says Sedgwick. “So trading activity is worse now than at the nadir of the 2008 financial crisis.”
Aronstein points to what he sees as an avalanche of regulations that has beaten down the ability and willingness of banks and primary dealers to take risks. “The appetite for risk has gone to zero,” he says. He contends that as legislators and regulators across the globe codified new laws and rules in response to the financial crisis of 2008, they apparently failed to adequately consider the potential impact on liquidity in the bond markets. “Unfortunately for the marketplace, banks and their like have been the source of all liquidity in the dealer markets,” Aronstein explains. “Bonds aren’t traded through the floor like stocks. There’s no exchange. There’s no physical centralization.”
Ostensibly, some of the key provisions in Basel III do not have to be fully implemented until 2019. Banks, however, are already largely operating under the new capital standards, according to Ben Powell, head of funding for the International Finance Corp., an affiliate of the World Bank, in Washington. IFC raises money in the bond markets for loans to private sector investment projects in developing countries. “The credit rating agencies are taking a very close view of that in terms of who’s ready for the new capital standards,” says Powell. “And if you’re not ready, I think that could be rating negative.”
Aronstein is concerned that a sudden loss of investor confidence in a given segment of the market could lead to the sort of calamity that hit the $350 billion auction-rate securities market in February 2008. That was when investors refused to roll over their shares in the fund for the weekly or monthly auctions and instead headed for the exits. As a result, auctions failed for many funds. “Auction-rate preferreds were sort of the safest form of investing,” recalls Aronstein. The fact that the auctions were suddenly failing in February 2008 illustrates something Aronstein says he has seen frequently in his 35-year career as fund manager: Market crises often emerge from sectors where no one expects them to occur.
Whereas crises may emerge from unexpected sources, Aronstein believes that funds holding emerging-markets and high-yield bonds are more vulnerable. Both markets have seen significant increases in bond issuance in recent years. Emerging-markets corporate borrowers have issued $1.2 trillion in bonds from the beginning of 2009 through December 3, according to statistics from Thomson Reuters. Global high-yield corporate issuance has totaled $1.6 trillion over the same period.
Without a market buffer, prices in any affected class of bonds or funds could fall sharply before the markets set a new price, says Aronstein. “So unless we’re fortunate and there are a number of sovereign wealth funds that have just been sitting and waiting for an opportunity to buy more of a certain category of bond, you have to get prices down to levels that [get] value guys in the hedge funds interested,” he explains.
In the new, illiquid bond market, dealers, lacking inventory, have to make extra efforts to execute trades, especially on the secondary market. “It used to be that before they take down paper in the secondary market, the bond traders would first call their risk department to update them on positions,” says Powell at IFC. “Now they’re picking up the phone to sales in order to have a buyer. They’re looking to off-load immediately.” Some banks now impose limits on the time bonds are held on trading books to 180 days, he adds.
Other market observers echo the concerns raised by Aronstein. “The reality is that there is a very real risk,” says Richard Prager, managing director and global head of trading and capital markets at BlackRock in New York. The issue, however, is bigger than the short-term bond sell-off of May and June 2013 and bigger than the fallout for mutual funds with a liquidity mismatch. “There’s a longer-term concern that the bond market itself is broken,” Prager says. “It’s been largely masked by this very accommodative Fed policy and the fact the new-issue market has seen enormous growth.”
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