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Investing Podcast recorded on June 19, 2015

Bond Market Liquidity

Podcast Transcript

Welcome to the Breckinridge Podcast. This is Chris Day, and with me today I’ve got Matt Buscone. Matt and I will discuss liquidity in the bond market. So Matt,liquidity is something that has been out in the press quite a bit of late, what does it mean to Breckinridge and how do we define it?

So the simplest explanation is that you can execute a transaction with some immediacy at a low transaction cost without affecting the price to a large degree. It's a hard topic to define. A lot of factors go into it, what's the size of the transaction, how do you define a low cost; liquidity can come and go. If you want to sell when everyone else is buying, you're in luck. You'd say you've got great liquidity. If you're looking to sell when everybody else is, not so much. The paradox is that most assets tend to be liquid when you don't need it, and illiquid when you do need it.

Right, without a doubt. So what factors can negatively impact liquidity?

So there could be a number of factors. I'd probably break them into two different categories. It could be a macro event, weaker economic data, negative mutual fund flows, probably bad geopolitical news, crowded trade or also known as a herding effect where everybody is trying to get in and out at the same time, or there could be regulatory changes in the market. And then, within a specific asset class, there could be micro events. There could be event risk regarding one particular company, there could be rating changes to a particular sector, the size of issue, the size of trade, or even basic supply and demand imbalances. And I think what we saw Nouriel Roubini write about lately was, his concern was, or his point was, that we've got a tremendous amount of macro liquidity from central banks pumping in cheap dollars everywhere, but there is very specific market illiquidity at certain times.

So what has all the recent buzz been about?

There have been several instances of market disruptions in the last few years that have brought this to a lot of people's attention. We had the equity flash crash in May 2010 when there was a 10% drop very quickly before recovery. We had the taper tantrum in 2013 where long-term interest rates rose by 100 basis points over two months, not really based on any economic news but more on a change in language from the Federal Reserve...


You had the treasury market flash crash in October of '14, 10-year yields fell by about 40 basis points in the span of a few minutes. Most recently you've had 10-year German bond yields go from 5 basis points to 80 over the span of a few days, so you've had multiple events where there have been very large swings in price, but there really has not been any fundamental change in the news. That's quite unsettling to a lot of people.

So are there other concerns about what might trigger a bout of illiquidity?

Yeah. I think the easy one to point to right now is interest rates. Obviously, it is still at historically very low levels on rates, and opposed to the last few years, when there was a pretty small chance of a Fed rate hike, the markets are almost certain that there will be a hike before this year end and perhaps multiple rates.

And if rates rise, there is a fear that that would cause a mass exodus from mutual funds and exchange traded funds. Both of those have seen a tremendous amount of inflow since 2008, and many investors have chosen longer duration funds or credit vehicles to enhance those returns, and they have not been through a period of negative returns at any point during those multiple years. How will they react to a rise in rates and perhaps negative numbers on their NAVs?

Yeah, without a doubt. So we understand interest rate concerns, but it seems a lot of what's been written lately is about the corporate bond market. Why is that?

So the corporate bond market has grown substantially since 2007. The outstanding supply is now 50% higher than it was and there's close to $8 trillion in outstanding corporate debt.


While at the same time you have had that debt growing, you've had dealer inventories decline by about 80% to levels that were held prior to the financial crisis and since the first quarter of 2013, dealer inventories of corporate bonds have stabilized between $50 and 60 billion, not a very big amount given the overall depth or overall size of the corporate bond market. So if you go through a period of net redemption and corporate funds are selling, and you've got broker dealers looking at their inventories and saying we're not willing to expand.

We're full, yeah.

Where does that excess paper go when people need to sell?

Right. So why has there been such a big drop in inventories over the last several years?

I think a big part of that change is the regulatory environment they're in. Obviously post crisis there were a number of changes made to shore up banks' balance sheets, and part of the Dodd-Frank and Volcker Rule frankly looked to prevent banks from making speculative investments that aren't related to activities on behalf of their clients. The result of that is no more proprietary trading as the higher capital costs have really cut into the probability of that.

So banks and dealers used to be able to step in during times of stress and provide a floor to the market so even though things got weaker, there was a clearing level that could be attained, and not likely to be the case this time around.

Right. So if we're trying to define a market that is less liquid, how might we measure that?

So we talked at the outset about how liquidity can be sometimes difficult to define, measuring it is often even more difficult. There was a Deutsche Bank study recently that looked at treasury market volatility and measured the number of transactions and divided it by the MOVE index which measures volatility and treasury prices, and this study showed that lower volume is having a greater impact on pricing. And while the metric isn't perfect, if you look at their chart, it's at the lower end of the range outside of the financial crisis than we've hit in the last 10 years, implying that there would be less depth to the bid, perhaps, and a wider swing in price as people try to transact more.

Yeah, so if we are saying that liquidity might be lower than it has been before, who would this most broadly affect?

You know, I would guess that the biggest impact is likely going to be felt by mutual fund and exchange traded fund owners. Mutual fund holders can be negatively impacted by the actions of other shareholders. What we've talked about a lot, increased redemption caused sales which pressures prices, and creates a negative feedback loop. Even if you don't liquidate, your performance suffers and as a shareholder that stayed in, you suffer the negative consequences of what others are doing.


Now ETFs that are promising intraday liquidity are often comprised of securities that can be very illiquid at times. Think of a high yield fund during a period of negative rating actions or outflows, people trying to sell intraday on that ETF, the ETF is trying to liquidate higher yielding or lower quality credits, the depth of the bid is not there, or a longer duration fund during a period of rising rates when there isn't a bid for longer securities, so...

Yeah, so it's really a mismatch of the vehicle's liquidity relative to the underlying asset liquidity.

Yeah, and the sentence I read best about it said you've got funds that provide daily liquidity on a basket of illiquid underlying securities.

Yeah, without a doubt. Now let's loop this back to Breckinridge. What do we do here that would protect portfolios from such an event?

So I think we take a longer term investment approach. We buy bonds that we would be comfortable holding to maturity if needed, and we aren't reliant on the market for the return of our capital. We take a credit-based approach, and we get to know our issuers better by not only looking at fundamental analysis and research metrics, but also more forward-looking measures with regard to ESG. That helps us know our issuers better and we can say, even if the market isn't providing a good bid or a bid that we deem acceptable, we're comfortable holding this issuer.


And the last is certainly investing in a better vehicle. We talked a little bit about mutual funds and ETFs being subject to the whims of other shareholders. Those that invest in a separately managed portfolio aren't going to be subject to some of the same swings and some of those flows that you see on the mutual fund side.

Yeah, and I'd also say illiquidity breeds opportunity a lot of times, correct?

Yeah, we saw it. You could highlight several opportunities, the financial crisis is easy, but also in 2010 and 2012, when there are disruptions or bouts of illiquidity and perhaps, you know, maybe it's the intermediate or longer end of the market, what does hold up even better is short-term, higher quality security. So when people are fleeing the longer end of the market, what they are saying is, I'll buy a high quality 2-year bond, 3-year bond. You've got very good liquidity on those, and you can oftentimes take advantage of those disruptions and pick up better or pick up securities at a wider spread in the longer end, so...

And that's something Breckinridge portfolios have a fair amount of, that dry powder, correct?

Exactly. Yeah, it's an allocation that has a diversified maturity structure, oftentimes with the heavier weighting to shorter securities that we can use to our advantage.

Excellent. Well, thank you very much, Matt. We appreciate it here, and hope that you in the field have found this informative. We look forward to having you join us next week.


DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.