When Verizon Communications issued $49 billion in bonds last year to finance its acquisition of Vodafone Group, investment managers, including BlackRock and Pacific Investment Management Co., raced to get a piece of the deal. Managers were not only after paper to meet the huge demand from mutual fund investors, but they also were seeking bonds that would be easy to sell in a crisis. Companies constantly sell bonds to the public, making each particular issue unique and hard to buy and sell in the secondary market. But a $49 billion bond offering gives its investors the security of knowing they likely have a buyer on the other side if they need one.
Before the financial crisis, money managers had little reason to worry about being able to sell their bonds. After all, Wall Street dealers were flush with borrowed money and engaged heavily in proprietary trading. Although that clearly ended badly in 2008, there was an upside for money managers and investors: Bond markets were highly liquid. Money managers could easily sell even the most esoteric bond in seconds.
A slew of regulations worldwide, including the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S., has curbed banks’ proprietary trading and increased capital requirements to support even the most prosaic bond trading. One casualty has been efficient fixed-income markets.
Verizon is not the only company that has been taking advantage of low rates as well as increased demand from mutual fund managers trying to position their portfolios for a possible liquidity crisis. Highly rated companies sold a record $1.1 trillion of bonds in 2013, including Apple’s $17 billion issue in April. At the start of this year, there was $3.3 trillion in bond funds, compared with $2.3 trillion in 2010. With the Federal Reserve continuing to scale back its bond-buying program, investors are expecting interest rates to rise and bond prices to fall — even if they have no idea when exactly that might happen.
Colin Robertson, managing director of fixed income for Northern Trust Asset Management, who oversees the Chicago firm’s $151 billion in fixed-income investments, doesn’t think a bond bear market is imminent. Yet he is still positioning his firm’s bond funds for a liquidity crunch. “Investors have voiced concerns about what will happen if there is a shock to the market,” he says. “My answer is that there won’t be a good ending.”
Whereas Robertson can’t go to the extreme of putting his funds into cash, he does want to make sure that he can be a buyer of bonds when investors start selling. Northern Trust doesn’t want to be a forced seller, because then the funds would have to dump the most liquid — by definition, highest quality — securities. As a result, it is holding more Treasuries than it would otherwise. The firm is also continually trading into more liquid securities, like newer bond issues. “This is why when new issues come out, they are always oversubscribed,” says Robertson.
The Northern Trust fixed-income chief believes that every bond manager should be scared about the lack of liquidity in the market and should be doing an analysis of what it needs to do to prevent forced selling. He says initiatives like electronic trading, which often can find alternative sources of buyers and sellers, only help on the margins.
To be sure, some of the largest managers, like BlackRock, are spending millions on initiatives to help with liquidity problems prompted by a restructured Wall Street. Other managers are making preemptive strikes. William Eigen, who, as the head of absolute return and opportunistic fixed-income funds at J.P. Morgan Asset Management, oversees a $36 billion portfolio, has been selling high-yield bonds for some time. He has been anticipating that the flows that have gushed into these funds in recent years would turn around and have to squeeze through a now narrow door. “You’ll be getting out through a pinhole,” he says. At one time, Wall Street dealers would have snapped up these bonds, held on to them until the market stabilized and then sold them at a profit. Now the banks can’t take the risk of holding such positions in inventory.
Government players have presented other solutions. The Federal Reserve is considering requiring redemption fees on certain bond funds to deter investors from fleeing during hard times. Well-respected managers, like Loomis Sayles & Co.’s Daniel Fuss, have said they like the idea. The Securities and Exchange Commission is also looking into whether the largest firms like BlackRock and PIMCO get better access to bonds like the ones Verizon issued last year. The SEC is also questioning if the big firms’ dominance might influence the markets when a crisis comes and perhaps make things worse for everybody in the process. Robertson says an exit fee would be damaging to the industry and push investors to exchange-traded bond funds, which have proved to be fairly liquid in times of stress, including the bond market rout in spring 2013.
But there are simpler ways to solve the bond liquidity problem. Managers can stick to higher-quality securities. Robertson says investors can stay with the top end of riskier asset classes like high-yield and emerging markets. Rather than moving into less-creditworthy companies within the high-yield category, they can move some money into emerging markets but again stick with the better credits.
The liquidity issue has also ignited a discussion about the value of active mangers in fixed income. “With passive, you don’t have the ability to position yourself in a liquid asset or balance a portfolio with cash,” says Robertson. At least there might be one beneficiary of inefficient bond markets.
Follow Julie Segal on Twitter at @julie_segal.
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