On this thread, some of us were saying leveraged liquidity will not last long: Excerpts From an article in today's WSJ:
The bond market's biggest worry these days isn't default or interest rates. It's illiquidity that is crippling the very workings of the market.
Illiquidity means it has become more difficult to buy or sell a given amount of any bond but the most popular Treasury issue. The spread between prices at which investors will buy and sell has widened, and the amounts in which Wall Street firms deal have shrunk across the board for investment grade, high-yield (or junk), emerging market and asset-backed bonds.
This illiquidity was a big motivator in the Federal Reserve's surprise decision Thursday to trim its target for the federal-funds rate by one-quarter percentage point. Bonds rallied Thursday on the move, but declined Friday. The 30-year Treasury bond fell $2.50 per $1,000 face value, pushing up the yield, which moves opposite to price, to 4.978%. The spread between its yield and that on other, riskier bonds narrowed a bit. Liquidity improved only slightly, and will likely take a long time to return to normal, analysts say.
The sharp reduction in liquidity has preoccupied the Fed because it is the lifeblood of markets. <<snip>>
In recent weeks, many Wall Street desks have been cutting back on the size of the trades they'll make, arequoting much wider bid-offer price spreads, or are not quoting markets at all, institutional investors say.
"There clearly is a weakness in terms of making markets," says Helen Peters, head of Scudder Kemper Investments' global bond group. "I'd have to assume that, given the losses of various firms, they're not willing to put their capital at risk and thus they're less likely to be taking large positions."
Harry Resis, a high-yield bond fund manager at Scudder Kemper, says many dealers have stopped quoting both bids and offers in high-yield or "junk" bonds.
"If you called them before the Fed cut, they'd sell what they were long and bid only for what they were short." A short position means borrowing and then selling a bond, expecting to replace it later at a lower, profitable price. "Some firms will quote two-sided markets," but the bid-offer spreads are very wide, he says. "In fairness to the dealers, to make a tight, low-margin market when risk is so enormous is not something you see very often."
Jude Driscoll, head of high-yield bond trading at Conseco Capital Management, said Friday that while junk-bond yields had not fallen noticeably relative to Treasury-bond yields since Thursday's rate cut, "I'm seeing more bids. A lot of days all you see is the offering." But he said investors may sell into any rally.
Mr. Driscoll says his desk has seen trading volumes fall 70% or more from normal levels in investment-grade, high-yield and asset-backed bonds. Meanwhile, bid-offer spreads have widened drastically, especially on high-yield bonds. For example, Mr. Driscoll says when MacSaver Financial Services, a unit of furniture retailer Heilig-Meyers Co., issued a 10-year bond to yield 1.6 percentage points over Treasury bonds last year, dealers typically quoted bids and offers that were 12.5 cents apart per $100 face value. Mr. Driscoll says when he last checked, with the bond yielding more than nine percentage points more than Treasurys, the bid-offer spread was $10 per $100 face value.
Joe Ballestrino, who manages investment grade corporate bonds for Federated Investors, says typical bid-ask spreads on those bonds have doubled to $1.50 per $100 face value from several months ago, while transactions have dropped to between $3 million and $5 million commonly, from between $10 million and $20 million. There are "lots of offers, not too many bids you'd want to entertain," says Mr. Ballestrino.
The most striking sign of illiquidity is the unprecedented spread between "on-the-run," or most recently issued, Treasury bonds, and those issued just slightly earlier, or "off-the-run." Their credit risk is identical and negligible. The widening thus reflects investors' willingness to accept the on-the-run bond's lower return in exchange for its liquidity. According to Salomon Smith Barney, the 29-year bond has gone from yielding less than 0.05 percentage point more than the current 30-year bond in early August to 0.27 point now, a spread the firm has never seen before. A similar spread has opened up for most Treasury maturities.
This suggests the bond market may have experienced more of a flight to liquidity than a flight to safety. Fed Chairman Alan Greenspan said Oct. 7 that investors snapping up the on-the-run bonds "are basically saying, "I want out. I don't want to know anything about whether a particular investment is risky or not. I just want to disengage." And the reason you go into these liquid instruments is that that is the vehicle which enables one to disengage as quickly as possible."
The on-the-run bond's liquidity premium hurts all other markets because dealers typically sell that bond short to hedge other bond holdings. The benchmark's rising premium has made such hedging riskier and dealers all the more reluctant to commit capital. Also, investors fear that hedge funds, such as Long-Term Capital Management, may have owned a lot of off-the-run bonds that they now might sell.
Thursday's Fed move trimmed the on-the-run bond's liquidity premium a tiny amount. Janet Showers, Salomon's government bond strategist, says, "I don't think the Fed easing 0.25 percentage point will make dealers less risk-averse. But it makes the longer-term money in the market feel more comfortable that the Fed is not going to sit by and let things deteriorate. It gives them confidence they can start returning to the market. If that type of customer does return to the market, that will help flows, and if flows get better, dealers will be more likely to take risk and position more securities."
Dealing with illiquidity takes creativity. Ms. Peters said one portfolio manager recently suggested rather than going through Wall Street, Scudder go to another fund manager and say, "We'd like to buy or sell a large block, what do you have?" Muses Ms. Peters, "We're getting to a barter economy."
Fund managers report that in many cases, Wall Street has gone from trading as principal to trading as agent, much as listed stocks typically do. Rather than buy bonds from a client, they offer to "work the order" over several days, matching seller to buyer. |
