Not every story is about fixed-income market structure and liquidity. But it’s starting to feel that way to me. One of the latest involves a suit by a Canadian pension plan against Boaz Weinstein’s Saba Capital Management in the New York Times last month. I immediately thought of how little easily accessible information investors have about the value of their bonds and other fixed-income investments. The suit alleges that Saba unfairly reduced the value of the pension’s portfolio before paying out a redemption request. Similarly, an Institutional Investor colleague is now looking into how various mutual funds value Puerto Rico municipal bonds.
How can the values of fixed-income instruments, traded in the largest market in the world, be so qualitative and slippery? Easy. Unlike equities, which trade on public exchanges, bond trading has historically been controlled by a handful of banks. It’s an over-the-counter market, which has no ticker flashing prices on CNBC. This isn’t a scandal; companies print bond issues all the time, each with different characteristics. When it comes time to sell, it can be hard to find a buyer, and vice versa. PIMCO’s chief investment officer for U.S. core strategies, Scott Mather, has compared the bond market to that for real estate. Few people list their houses on a website and expect to find a buyer. Instead, they pay an agent, who may know a young couple interested in a fixer-upper next to the railroad tracks. Both bonds and houses are far from homogeneous. Real estate brokers have maintained their grip on their market, despite consumers buying everything from groceries to puppies online. “You can’t force every house to be the same or force every issuer to issue the same bond,” says Mather. Since the financial crisis, though, players in the bond market have become more receptive to technology and new solutions. They’ve had to as banks have been regulated out of playing their traditional role as market makers and, in a pinch, providers of liquidity.
While I’ve been reporting on bond-market structure for a number of years now, I’ve wanted to write the larger story of how it got to be this way, how it works now as opposed to in the past and what the future might look like. It’s easy to get fixed-income managers to talk about concepts; it taps right into bond geeks’ inner financial historians as much as their concern about a potential flare-up in markets. Liquidity is financial doublespeak for the ease of finding a buyer or seller for your asset, whether it’s a Picasso or a complex derivative instrument. If there are few prospects in the market — little depth in the pool — investors may quickly hit bottom and have to sell what they believe is a valuable item at a big discount. Writing about liquidity (or illiquidity), even with a lot of colorful characters, puts a reporter in the dicey position of either lulling readers to sleep or oversimplifying so much that the concept loses its nuance or becomes downright wrong.
Phil Barach, co-founder of Los Angeles–based fixed-income house DoubleLine Capital, made me see the humor in liquidity when we were at lunch a few months ago in New York’s Union Square. Barach regaled me with stories of his competitors complaining and shrieking in the press about liquidity and market infrastructure problems. To him, it’s really all about investors not liking prices they are getting for their bonds. The complaining, the worrying, the talking weren’t getting anybody anywhere. “Let’s all gather in the conference room and sit around being concerned. There, I’m anxious. That’s helpful,” he quipped, crossing his arms and pursing his lips.
People are nervous because they’re thinking about 2008, when it seemed as if you couldn’t sell anything. But Barach’s point about people not liking prices they are getting is well taken. One prominent hedge fund manager recalls watching television pundits in 2008 saying the market for mortgage-backed securities had shut down, when he had completed multiple trades just that day. Yeah, the prices weren’t great, but there was a buyer out there if you really needed the cash.
That’s when I started talking to people who have watched the fixed-income market over time and could tell me the history. High-yield expert Marty Fridson recently chaired the New York Society of Security Analysts’ high-yield conference, where money managers unanimously agreed that the No. 1 question they get these days is about liquidity, not returns. It’s not clear to him how much worse things have really gotten. In fixed income “dealers never fell on their swords to prevent the market from going under,” Fridson tells me. “In good times dealers would say, ‘We’ll always have a bid’ during stress. But they didn’t. They hid under their desks,” he adds.
Fridson shares a story of speaking at a conference years ago. He had put together an elaborate analysis of the yield premium on high-yield bonds. Part of the analysis reflected the compensation investors wanted for accepting the risk of defaults, including an additional amount to compensate for the relative illiquidity of junk bonds. The analysis stirred up Stan Phelps, another colorful high-yield bond pioneer. “As I was talking about how the illiquidity premium would be greater some times than at others, et cetera, Stan pipes up and says, ‘This is baloney. When the price falls to the right level, there will be liquidity!’”
Of course, Fridson agrees that market structure has changed. He also emphasizes that while regulators may want more transparency and certainty, most markets operate more like the one for corporate bonds than like a stock exchange. “Think of the millions of muni bonds. Most don’t trade on a given day, and there is no one standing there making a continuous market. That would be suicide,” he says.
Fridson is confident, though, that banks or the new buyers of last resort, hedge funds, will come out of hiding once bonds fall far enough in value to make it worth their while to step in and buy.
