People think bonds are boring, but that’s only because they haven’t read Alain Badiou.(1) In any event, the subject of bond trading makes the subject of bonds in general seem positively sexy. But, like it or not, if we want to understand whether we should be worried about liquidity in the bond markets, we have to understand something about how bonds are bought and sold.
In this post I’ve tried to keep the discussion simple and straightforward, in part to avoid terminal ennui, but also because I know almost nothing about how bonds are traded. So with that in mind, and with the blind leading the bored, let’s plunge into the exciting world of bond trading.
We’ll start, as we should, with the broker-dealers of the world. These folks are called broker-dealers for a reason: they sometimes operate as brokers, usually on the equity side of the house, and sometimes as dealers, usually on the bond side of the house, and there’s a world of difference.
Suppose you (you’re A) are managing a large equity mutual fund and you want to sell some stocks. Your trading desk contacts B, a broker, who matches you up with C, who wants to buy those stocks. B, the broker, isn’t really a central player in this transaction. He’s a matchmaker who charges a (hopefully small) commission for his efforts. Like Match.com, the broker introduces the party of the first part to the party of the second part, but doesn’t actually go out on the date.
But now suppose you, A, are the portfolio manager of a bond mutual fund and you want to sell some bonds. Your trading desk contacts D, a dealer, who will bid on your bonds with the idea of buying them, then marking them up and selling them to C. In fact, your trading desk will contact a whole bunch of bond dealers and seek bids: a large bond fund may deal regularly with thirty or forty dealers. Once your trading desk has identified the high bidder, that bidder is contacted and informed that he suffers from the “winner’s curse:” the good news is, he owns the bonds; the bad news is, he paid more for them than anyone else was willing to pay.
Unlike the broker side of the broker-dealer house, the dealer side actually commits the firm’s capital. True, the dealer might buy the bonds from A – you – and sell them instantly to C. But the dealer might also end up holding the bonds in his inventory for some extended period to time, probably because he couldn’t sell them at a profit.
Brokers are almost incidental to the buy-sell transaction and are gradually being replaced by computers, but dealers are integral to the transaction. They are committing their capital and making markets in bonds, and if liquidity is going to be good or bad in the bond markets, it’s likely going to be good or bad because of what these dealers are doing. So who are these guys?
Bond dealers range from the usual subjects – large banks and investment banks and wirehouses like JP Morgan, Citi, Merrill, Goldman, Morgan Stanley – to small, regional boutiques nobody has ever heard of. When A’s trading desk solicits bids on a specific issue of bonds, it’s these dealers who respond by submitting the bids and standing behind those bids.
Of course, every dealer doesn’t bid on every transaction. Some dealers, especially the smaller houses, like to specialize in certain kinds of bonds. Some dealers may be capital-constrained at the moment. But, under normal circumstances, a lot of dealers will bid and A’s transaction will close smoothly.
What can go wrong? Well, if you listen to folks like Jamie Dimon, CEO of JP Morgan, the answer is “a lot.” Naturally, it’s important to remember that Dimon never met a regulation he didn’t hate, but even so he runs an institution that is extremely important to the health of the bond market, so let’s look at what he says we should worry about.
Dimon claims that, while the folks who wrote Dodd-Frank were trying to prevent the next financial crisis, what they’ve actually done was to ensure that it will happen. The mistakes Dodd-Frank makes are many and deplorable (according to Dimon), but there are two we should be thinking about for our purposes today:
First, Dodd-Frank – and Basel III – raise capital requirements on banks(2) across-the-board. Since banks now have to use their precious capital in other ways, there is less of it available to use making markets in bonds. This mainly effects the so-called “front book,” the inventory of bonds banks keep on hand to facilitate trading and make markets. As bank capital has migrated elsewhere to meet reserve requirements, the front book of banks has declined precipitously. We’ll take a look at this phenomenon in a moment.
Second, Dodd-Frank wants to reduce risk-taking by banks, which affects the “back book,” or “prop book,” where banks trade their own proprietary capital. This is known as the Volker rule. Like the front book, the prop books of banks have shriveled post-Dodd-Frank.
There is little doubt that Dimon is right when he warns that banks’ ability to maintain liquidity, avoid order imbalances and ensure the smooth functioning of the bond markets has been significantly reduced. And there’s another reason why bond inventories have declined at banks. Other government actions – in this case the Fed – have caused interest rates to decline to historically low levels. In the good old days – pre-2008 – a bank holding a large inventory of bonds on its books was at least getting a nice current return while it was holding them. But today, with returns perilously close to zero, the current return doesn’t justify the risk.
To put some numbers around all this, consider that in 2007 bank inventories of corporate bonds totaled close to $300 billion. That was against a total US corporate bond market of just under $2 trillion. Today, dealer positions have shrunk to about $60 billion against a vastly expanded corporate bond market of $3.7 trillion.(3) (Everybody and his dog has been issuing bonds to lock in low rates.) In other words, the ratio of the deep inventory to total bond market went from 0.15 in 2007 to 0.016 today – it’s ten times worse.
Another way of looking at this is to compare the size of dealer inventories (where liquidity is maintained) with the size of bond investment funds, which need the liquidity. According to the Fed, in 2007 bond funds held three times the bonds held in dealer inventories. Today, bond funds hold twenty times the dealer inventory.
All this sounds alarming, but does it really matter? We’ll look at that in my next post.
(1) Maoist philosopher.
(2) I’m focusing on bond dealers who are large banks because, at the end of the day, they are the ones who matter. These are the dealers who maintain so-called “deep” inventories of bonds. The smaller, regional dealers add liquidity to the bond markets on a day-to-day basis, but they are too small to make up for bank-dealer liquidity if the deeper players should go away.
(3) These numbers (rounded), and parts of this discussion, were taken from a presentation prepared by my Greycourt partner, Matt Litwin. Any errors were introduced by me.
Next up: Should We Worry about Liquidity? (Part 3)
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.