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Credit Market Liquidity – A Looming Threat?
I’m the innocent bystander
Somehow I got stuck
Between the rock and a hard place
- Warren Zevon
Credit assets have enjoyed a healthy rally year to date in 2014. Through the end of July, the Barclays
Global Aggregate Index has posted gains of approximately +4.0% while the Barclays Global High
Yield Index has advanced approximately +4.7% for the same time period. These gains in 2014 mark
the continuation of the largely uninterrupted rally in fixed income securities from the lows seen in the
depths of the 2008 financial crisis. For example, since the widely regarded market bottom in March
2009, the Barclays High Yield Index has advanced over +145% on the back of record issuance
volumes as companies strive to take advantage of an attractive financing environment and investors
scramble to satisfy their seemingly insatiable demand for yield in the face of the “new normal,” low
interest rate environment. While easy monetary policy and low interest rates have undoubtedly been a
positive tailwind for credit, the improvement of financial conditions within both the public and private
sectors of the United States economy has also been a fundamental driver of returns.
However, despite these positive trends, new structural weaknesses within the credit markets are
beginning to emerge. In Massey Quick’s most recent quarterly market newsletter, we included the
following quote from one of our long/short credit managers:
“Last but not least, the third issue is what we have started to call ‘the other L word’ ‐ liquidity. We
are referring here to transactional liquidity. Much has been made of the fact that the financial system
and counterparties to the system are not as levered as in 2008 and this is touted as a source of
stability. The dirty secret no one wants to talk about is that, in our opinion, the structure of the market
today is completely different from 2008. The effect of the new regulatory environment, regardless of
one’s opinion as to whether the regulations are good or not, is that transactional liquidity is bad.
Banks are no longer intermediaries in the transfer of risk. We think regulation has prevented this and
the traditional roles that Banks could play as a shock absorber in times of stress are gone….Our point
here is that the effects of the system being less levered may be equaled and perhaps outweighed by the
lack of transactional liquidity or ‘someone to take the other side.’”
Massey Quick’s investment research team has been actively reviewing broader credit market
conditions over the past several months. These studies have revealed several striking data points that
provide compelling evidence in support of the above manager’s assertions. The structural qualities of
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the credit markets that represent the largest potential issues can be most readily summarized as
follows:
Point One – Credit market intermediary risk taking is significantly lower, resulting in far less
overall market liquidity. Moreover, increased retail participation in these markets will
exacerbate this situation and amplify pressure on the fixed income markets.
Consider the following chart, which tracks both the amount of bonds retained on the balance sheets of
banks / primary dealers (blue line) and the assets in fixed income mutual funds and ETFs (orange
dashes):1
As can be seen, dealer activity in credit markets has fallen sharply since the financial crisis. The wellpublicized reforms as part of Dodd Frank and the Volcker Rule place definitive limits on major
financial institutions’ ability to both warehouse risk on their balance sheets and engage in proprietary
trading. In the face of these heightened regulations, banks have expectedly reduced their overall level
of market involvement.
In contrast, assets in fixed income ETFs and mutual funds have continued to soar as retail investors
seek cost-effective exposure to products that meet their yield needs. This influx of assets engenders
three noteworthy potential ramifications:
1
Source: Federal Reserve, Bloomberg, ICI
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Retail investor flows into mutual funds and ETFs have a well-documented history of being
both dramatic in scale and ill-timed. In the event that credit markets experience a correction,
retail investors may quickly unload their mutual fund and ETF holdings en masse in an effort
to avoid losses. This selling activity will put further price pressure on the underlying credit
instruments held by these funds as the fund managers sell assets to meet redemptions. With
dealers less involved in credit markets as a whole, there are obvious questions as to who will
emerge as a buyer of these assets in times of stress.
There is often a fundamental liquidity mismatch between the investments held by mutual
funds/ETFs and these investment vehicles’ capital bases. Consider the example of leveraged
loans, another corporate debt instrument that has seen a boom in popularity among both
institutional and retail investors. The average settlement period for a leveraged loan transaction
can be in excess of twenty days. This figure sharply contrasts with the daily liquidity afforded
to retail investors participating through mutual fund and ETF products. In the event of a
pronounced market sell-off, settlement and execution risks may increase and will likely
exacerbate price declines.
The rise of mutual funds and ETFs have created several large market participants with the
ability to impact prices during times of stress. For example, the giant investment firm PIMCO
manages over $500 billion in mutual fund fixed income assets that is subject to the whims of
its largely retail investor base. One can quite simply ask, “Who is large enough to help handle
the other side of PIMCO’s trading activity?” The activity of such a large market participant
during times of stress will have an undoubted impact on asset prices and further highlights the
potential structural inability of the broader market to absorb selling.
Point Two – Liquidity among still-active market participants is also generally poor due to less
attractive financing conditions.
The second quarter saw an increased number of high-profile news articles (including publications by
Bloomberg and The Economist) questioning the health of the repurchase agreement (“repo”) markets.
Repo agreements are an integral part of credit markets because they work to facilitate buying and
selling among market participants. A basic example of a repo agreement is as follows: one market
participant (“Player 1”) sells a security to a second market participant (“Player 2”) at an agreed upon
price while simultaneously committing to buy the same security back at a later date at another (often
higher) agreed-upon price and including interest. By engaging in this transaction, both of these
hypothetical market participants are able to meet their respective funding and liquidity needs. In this
example, Player 1 may not have cash readily available to complete an investment. As such, he may
send Treasury bills to Player 2 on repo and use the cash received to facilitate the immediate buying of
a security such as a corporate bond. Player 2 may be in need of short-term collateral and holds the
Treasury securities sent by Player 1 as this collateral while earning interest for the cash lent. Despite
being generally short-term in nature, as noted, repo transactions are an integral cog in the overall
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credit market wheel since they are used by a wide variety of investor types (ranging from institutional
money managers to money market funds) to facilitate transactions over a short window of time.
Repo activity has also fallen as a result of increased regulations placed on large financial institutions.
These regulations are of a somewhat different nature than the limits placed on proprietary trading and
risk capital described above. Instead, as The Economist succinctly notes, “[two] particular regulations
– the net stable funding ratio and the supplementary leverage ratio – seem to be discouraging banks
from taking part in repos, by making it more expensive for them to own short-term debt.”2 This
anecdotal statement is backed up by observed data: observed repo agreement volumes in 2013 were
down approximately 42% from peak levels seen in 2008.3
A continued decline in repo financing activity poses the potential to exacerbate price declines in credit
markets as willing buyers may not be able to secure their desired financing in the face of risk-off
selling. Massey Quick’s research team has closely discussed repo market conditions with our
alternative credit managers and we believe that they are well-positioned to navigate future difficulty
through an avoidance of crowded exposures and niche, non-repo financing facilities.
Point Three – Trading volume across a variety of fixed income instruments is down.
An expected byproduct of the lack of dealer intermediary activity has been an overall decline in credit
trading volumes. In reviewing transactional data, the decline in activity, even over brief intervals, can
be fairly dramatic. For example, the one month moving average trading volume for mortgage backed
securities (“MBS”) has declined by 19% from the beginning of 2012 to the end of 2013. When
considering the same time period, the one month moving average trading volume for corporate bonds
has declined by nearly 37%.4 Additionally, trading volumes in Treasury securities and agency
mortgages have been meaningfully impacted by the Federal Reserve’s unprecedented bond buying
activity in these markets as part of quantitative easing measures. For example, even after beginning to
taper its asset purchases, the Federal Reserve still accounts for a significant portion of the agency
MBS market, often purchasing more than 70% of a given month’s gross issuance in late 2013 and
early 2014.5 Much like the questions raised above regarding the presence of a large market participant
such as PIMCO, markets should rightfully begin to question demand levels in certain markets as the
Fed continues its planned exit of QE.
2
“Neither liquid nor solid.” The Economist. July 2014. (http://www.economist.com/news/finance-andeconomics/21606835-where-next-financial-crisis-may-appear-neither-liquid-nor-solid)
3
Source: Federal Reserve, Bloomberg
4
Source: Federal Reserve
5
Ibid.
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One potentially meaningful impact of reduced trading volume revolves around the issue of price
discovery. First, infrequent trading could lead to less readily available pricing data on certain
segments of the credit markets thereby engendering greater uncertainty during times of stress. Second,
a lack of trading volume could potentially lead to wider bid-ask spreads within credit markets. While
this set of circumstances might create attractive entry points for opportunistic buyers of risk during a
market dislocation, it will likely prove to be an adverse set of circumstances for the far larger crowd of
retail products discussed above as these managers seek to sell securities to manage exposures and
outflows.
Conclusion
While the timing of an eventual market correction is ultimately unknowable, we believe that a
knowledge of current structural dynamics within the credit markets will facilitate a more thorough
understanding of potential risks bubbling beneath the surface. The Fed’s continued tapering and
eventual exit of QE has led to obvious questions about the timing and magnitude of their next policy
measure: interest rate increases. Markets are clearly sensitive to this subject and July provided a
glimpse of this as credit instruments traded lower following comments from several Fed governors
that interest rates could rise sooner than previously predicted. While these interest rate increases aren’t
the only potential disruptor of credit markets, a movement on this front could prove to be the
proverbial “first domino.”
As noted, Massey Quick’s investment committee and research team have been proactively reviewing
exposure to these potential risk factors across client portfolios. For long only investments, asset
allocation continues to be biased towards high quality issues with minimal duration risk,
characteristics that should mitigate drawdown potential in a pronounced sell-off. We have also been
actively incorporating more high quality, floating rate exposures as part of long only fixed income
allocations where appropriate. While the return potential of these strategies is generally lower than
their more directional peers, we believe that the risk/reward profile of these investments is better
suited to current market dynamics. In a near-term validation of our positioning, we were pleased to see
these investments, despite being long only, protect capital well during a difficult July relative to the
broader fixed income markets. Within the context of our alternative credit managers, we are pleased to
note that they are highly engaged with managing potential risks through a variety of proactive
measures including (but not limited to) alternative financing sources, a careful avoidance of crowded
longs that are owned/over-owned by retail products, disciplined alpha short exposure to many of these
same crowded names and systemic portfolio hedges.
As always, we welcome your questions or comments at any time. Please do not hesitate to contact us.
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IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of
investments involve varying degrees of risk, and there can be no assurance that the future performance
of any specific investment, investment strategy, or product (including the investments and/or
investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any noninvestment related content, made reference to directly or indirectly in this newsletter will be
profitable, equal any corresponding indicated historical performance level(s), be suitable for your
portfolio or individual situation, or prove successful. Due to various factors, including changing
market conditions and/or applicable laws, the content may no longer be reflective of current opinions
or positions. Moreover, you should not assume that any discussion or information contained in this
newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey,
Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any
specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the
professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a
certified public accounting firm and no portion of the newsletter content should be construed as legal
or accounting advice. A copy of Massey, Quick & Co., LLC’s current written disclosure statement
discussing our advisory services and fees is available for review upon request.
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