More complex trades and less liquid instruments are still voice traded – FOW estimate that 50% of U.S. government bonds and 80% of credit markets and corporate bonds are still traded telephonically. Although advances in technology and regulatory pressures will drive increased electronification, there will always be a place for voice.  FULL ARTICLE

Fixed income managers agreed that any moves to boost liquidity are welcome, they fear the open information within these projects could leave markets vulnerable to price fluctuations. Full Article

The question that begs to be asked is: Could we enhance the corporate bond picture by reducing the number of issues outstanding, concentrating trading activity and thus increasing ‘liquidity’?

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As I approach the end of one decade and the beginning of another, I realize that I have found historical context has served me well in understanding how I might behave in almost any given circumstance.  While this personal perspective may prove useful, by its very nature it is personal and is limited by my own experiences. With this in mind, I’ve come to rely on the web to deepen my personal knowledge as well as learning from others.  The wisdom of age combined with an appreciation for information technology and respect for informed viewpoints can be very powerful.

For some perspective, the market has experienced a 3-decade bull market in bonds which was preceded by a severe bear market of rising rates to battle inflation. Armed with the knowledge of modern analytics, I asked the omnipotent web gods a simple question; “what were bond fund outflows in 1980?”

The query returned a number of results, but the one that I found most relevant was a paper published in the FRBNY Economic Policy Review of July 1997 entitled  “Market Returns and Mutual Fund Flows” written by Eli M. Remolona, Paul kleinam and Debbie Grunstein.

I’ve selected sections that I thought were more relevant to the current dilemma and offered them for your review below.  What I found most helpful in presenting a visual representation of their research as data analysis is Chart 7 on page 13.  This is a representation of the relationship between market declines in mutual fund liquidity ratios as measured by fund managers’ reactions.

Here’s the chart:

This is the summary of fund managers’ reactions to market conditions:

FUND MANAGERS’ REACTIONS

“Fund managers may react sharply to abrupt market declines and thus could exacerbate the effects of the outflows.  For instance, to meet redemptions, they may either draw on their funds’ liquid balances or sell off portions of the portfolio. Or they may go further still by selling more securities than they need to meet the redemptions.  Indeed, in four of the five episodes summarized, average liquidity ratios rose in the month of the market decline, indicating that the fund managers sold more than they needed to meet redemptions (Chart 7). In three episodes, the liquidity ratio continued to rise in the following month. Nevertheless, the reactions of fund managers fell well short of a panic. Faced with heavy redemptions and the possibility that current outflows could lead to more outflows in the near future, the fund managers took the reasonable step of adding to their liquid balances. Moreover, in the five episodes of market decline, the average liquidity ratio never rose by more than 2 percent of net assets and never exceeded the highest levels reached in periods without major market declines.”

Is it really different this time or are we simply looking at the abyss and afraid of the implications of a bear market?  To save you from reading the entire paper, I have outlined some of the key sections that illustrate previous reactions to major market moves…..you are welcome.

THE EFFECT OF MAJOR MARKET DECLINES

“To characterize the effects of market returns on mutual fund flows, it is important to examine whether large shocks have special effects. Our instrumental-variable analysis assumes that the effects on flows are proportional to the size of the shocks. We now assess this assumption by taking a closer look at mutual fund flows during five episodes of unusually severe market declines (Table 7).   We also look for evidence that the flows perpetuated the declines. The market declines were most pronounced in the bond market in April 1987 and February 1994, in the stock market in October 1987, in the stock and high yield bond markets in October 1989, and in the municipal bond market in November 1994.  Although these were the markets most affected, price movements in other markets also tended to be significant; therefore, we also take these markets into account. Finally, we examine whether the funds’ investment managers tended to panic and thus exacerbate the selling in the markets.”

THE BOND MARKET PLUNGE OF APRIL 1987

“In the spring of 1987, Japanese institutional investors pulled out of the U.S. stock and bond markets after the threat of a trade war between the United States and Japan precipitated a sharp dollar depreciation (Economist 1987).  In April, government bond prices plunged an average of 2.3 percent, while stock prices and other bond prices also fell. Taking into account the decline in the government bond and stock markets, our instrumental-variable estimates would have predicted unexpected outflows from government bond funds of 1.2 percent of net assets.

Actual unexpected outflows were 1.8 percent, much greater than predicted but still bearing little resemblance to a run. Although there is some evidence that the flows served to perpetuate the decline, the magnitudes were still too small for a self-sustaining decline. In May, the unexpected outflows from government bonds rose to 2.9 percent of net assets, while bond prices continued to fall. However, flows and prices recovered in June.”

THE BOND MARKET DECLINE OF FEBRUARY 1994

“In February 1994, the Federal Reserve raised its target federal funds rate 25 basis points. The increase, the first in a series, was not altogether a surprise, but prices of government bonds still fell by about 2.1 percent. Stock prices also fell.  Given these developments, we would have predicted unexpected outflows from government bond funds of 0.8 percent of net assets, an estimate that is close to the actual figure of 0.9 percent. Unexpected outflows rose in March and bond prices continued to decline, but the magnitudes remained unimpressive. Prices started to stabilize in April.”

THE MARKET DECLINES OF NOVEMBER 1994

“In November 1994, the Federal Reserve again raised its target federal funds rate—this time by 75 basis points, a larger increase than most investors had anticipated. In addition, the troubles of the Orange County municipal investment pool came to light later in the month. Stock and bond markets experienced substantial declines, with municipal bond prices falling by 1.4 percent during the month. Taking these market movements into account, we would have predicted unexpected outflows from municipal bond funds of 1.2 percent of net assets, yet actual unexpected outflows were 1.4 percent. The inflows in December exceeded the outflows in November.”

FUND MANAGERS’ REACTIONS

“Fund managers may react sharply to abrupt market declines and thus could exacerbate the effects of the outflows.  For instance, to meet redemptions, they may either draw on their funds’ liquid balances or sell off portions of the portfolio. Or they may go further still by selling more securities than they need to meet the redemptions.  Indeed, in four of the five episodes summarized, average liquidity ratios rose in the month of the market decline, indicating that the fund managers sold more than they needed to meet redemptions (Chart 7). In three episodes, the liquidity ratio continued to rise in the following month. 

Nevertheless, the reactions of fund managers fell well short of a panic. Faced with heavy redemptions and the possibility that current outflows could lead to more outflows in the near future, the fund managers took the reasonable step of adding to their liquid balances. Moreover, in the five episodes of market decline, the average liquidity ratio never rose by more than 2 percent of net assets and never exceeded the highest levels reached in periods without major market declines.”

CONCLUSION

“To the extent that the effects of returns on flows are present, they seem to be stronger for the funds with relatively conservative investment objectives, such as government bond funds and income stock funds, than for those with relatively risky objectives, such as growth stock funds, GNMA bond funds, and high yield bond funds. We also find that these effects have been stronger in certain episodes of major market declines, although still not strong enough to sustain a downward spiral in asset prices.”

Like I said, the wisdom of age combined with the internet and respect for informed viewpoints can be very powerful. Perhaps the next time you hear someone proclaim to know the dangers of the next market crisis, you should ask them to SHOW THEIR WORK.

Chris Ferreri

Eight Point Strategies

All these solutions miss the point, however. None focus on the real reason behind deteriorating liquidity, which is that vast swaths of the corporate bond market have simply been cornered.   FULL ARTICLE

“It’s Bond Math 101,” especially for Apple’s record-breaking $17 billion of bonds sold in 2013, right before benchmark yields rose, said Jody Lurie, a corporate-credit analyst at Janney Montgomery Scott LLC in Philadelphia. “When rates rise, there’s only one way to go, at least prior to it going to maturity, and that’s down.”

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Our recommendations take a three-pronged approach: (i) market structure modernization, (ii) enhance fund “toolkit” and regulation, and (iii) evolution of new and existing products

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A $7.9tn corporate bond market would benefit from a futures contract and put it on par with every other major asset class in the world. Are you with me? Full Article

The benefit of banks no longer warehousing as much bond risk, is that S&P doesn’t think they’ll be particularly vulnerable in the event of a big bond sell-off. The downside is that all those funds and vehicles that large and small investors have been using to snap up debt — such as exchange trade funds or mutual funds  are more susceptible to such an event since they promise ‘instant’ liquidity on what may prove to be illiquid underlying assets.

Trace was instituted in 2002, and it’s fairly clear that it’s helped liquidity in most cases, especially for retail investors and institutional trades of less than $1 million. For trades above $1 million, some prominent asset managers are advocating to delay reporting to either an end-of-day tape or T+1 or T+2 reporting. Full Article