
People Are Worried About Bond Market Liquidity - dsri
http://www.bloombergview.com/articles/2015-06-03/people-are-worried-about-bond-market-liquidity
======
bcg1
People _should_ be worried about bond liquidity.

In a normal interest rate environment, bonds are income producing instruments
and if you don't need to sell and are ok with the interest rate, liquidity
doesn't matter quite so much. However with near-zero rates for the last 5-6
years, bonds are only making money as long as there is actual deflation (which
however increases default risk) or if yields keep dropping (which beyond zero
becomes some weird sort of Einstein-Bose finance where people pay others for
the privilege of lending them money). In this type of environment you can't
just hold the bond to maturity and live off of the income... to cash out you
must sell, so liquidity is critically important.

The "flash crash" rhetoric in the article is a red herring. Much more
troubling would be an actual fundamental shift in the market... the bonds
markets are so huge that even small moves could prove to be seismic...

I've always thought that preventing this was the true purpose of QE, and is
the reason that the Fed quadrupled its balance sheet with little effect on the
headline CPI or other mainstream measures of inflation... however it might not
be a stretch to say that the hyperinflation that all the doomers were
predicting is playing out in the bond markets. If that is the case, and the
liquidity dries up because QE is over and everyone who was frontrunning the
Fed decides to cash out... yikes

~~~
rrggrr
Liquidity has to flow somwhere and in the instant case its likely to
treasuries if other bond classes crash. As destabilizing as that would be for
holders of the distressed bonds, and for borrowers who need to raise capital,
its arguably very stabilizing for treasuries and offers the Fed its long-term
exit from unprecedented balance sheet inflation. Treasury holders will be
paying the cost for the Fed to retire debt as I see it.

~~~
bcg1
I agree I think that dynamic could definitely play out... I'm less sanguine
about how orderly such a shift would be in practice however, and the level of
complexity in financial markets today I am skeptical that destabilization
would be limited to holders of distressed bonds (even if it was, those
bondholders are probably major institutions whose problems could lead to more
bailouts, derivatives being triggered, etc)

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lmm
I've long thought there _should_ be an efficient-markets solution to flash
crashes. If the majority of sudden price drops are flash crashes and not
fundamentals trading, then someone ought to be able to print money by simply
resting a big bid 19% (or however low you can go without tripping the circuit
breaker) below the current price, for everything, every day, and cashing in
when the price crashes and rebounds. That would smooth out the crashes without
any need for external intervention.

So why is no-one doing this?

~~~
jasode
_> , and cashing in _when_ the price crashes and rebounds._

[my emphasis on " _when_ "]

I think the "when" is a huge part of the puzzle. How can an algorithm _know_
the difference between a flash crash that will get remedied within 24 hours vs
a longer period of irrational pricing that takes months to sort out?

For example, at the time of the famous LTCM downfall[1], it held several
arbitrage positions that were _eventually_ proven right... but they didn't
have sufficient capital reserves to survive the short term irrational spreads
(Russian default, flight to US Treasuries, etc). I'm not saying that LTCM
didn't have many other flaws of risk analysis that would have also caused
their downfall but in that one case, it was an illustration of " _the markets
can remain irrational longer than you can remain solvent._ "

[1][http://www.amazon.com/When-Genius-Failed-Long-Term-
Managemen...](http://www.amazon.com/When-Genius-Failed-Long-Term-
Management/dp/0375758259)

~~~
rlucas
GP is talking about a long-only flash-crash arb strategy -- so assuming you're
not buying on margin you don't have the need to have capital reserves to
"survive" until the recovery.

Of course, especially these days in the markets, whatever _can_ be leveraged,
_will_ be leveraged...

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acd
The central banks are printing money like crazy driving down interest rates
below the historical average of 5.5% interest rate. This jacks up stocks
prices and pushes up a new tech bubble. Who knows where we will end up another
pets.com maybe?

[http://en.wikipedia.org/wiki/Pets.com](http://en.wikipedia.org/wiki/Pets.com)

~~~
brc
Sarbox rules have made it very difficult to list a company.

No more pets.com because no more floats.

When was the last time you heard about a small operation with little revenue,
no profits and not much of a business model getting floated ?

These days it just doesn't happen much. The floats are all giants like
Facebook. Back in the late 90s these things were listing monthly.

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jackgavigan
I don't think there's a real problem here, except for forced sellers - I would
pity an investor who is forced to liquidate a corporate bond portfolio because
of a margin call. But liquidity risk (especially in the corporate bond market)
isn't exactly news to anybody.

Liquidity for US Treasuries may well be lower because the Fed's taken so many
of them onto its balance sheet[1] but I don't think that a lack of liquidity
is going to pose a real problem in that market. There's a difference between a
market that's dislocated (by which I mean that the market price has deviated
from the "real" value of the asset) due to a structural problem (like a lack
of liquidity), and a market that has reached its peak (and/or is overvalued,
and is undergoing a correction - which may be happening in Europe at the
moment[2]).

People get all excited about flash crashes and talk about billions of dollars
being wiped off the value of whatever but it's complete horseshit. Just
because a few trades happen at an unreasonable price because of a technical
hiccup (or because of some strange, unforeseen interaction between different
automated systems) doesn't mean that the underlying value of the asset in
question has changed. If a share starts the day at $100, dips to $1 because of
a flash crash, then recovers to $100, what has really changed? A few people
may have made/lost money by being lucky/unlucky enough to have traded at an
incorrect price (e.g. because a stop-loss got triggered or something) but
other than the appearance of an icicle-shaped spike on a chart, it's just
noise (and if you have a system which reacts to noise, then the problem lies
with your system, not the market).

Personally, I think the bond market has been propped up by "quantitative
easing", which has, in turn, inflated the equity markets. At some point, that
situation has to undergo a correction and that could well manifest itself as a
crash if everyone dashes for the exit at the same time. But that's the nature
of markets - they fluctuate, sometimes wildly.

1:
[https://research.stlouisfed.org/fred2/series/TREAST](https://research.stlouisfed.org/fred2/series/TREAST)

2:
[http://www.ft.com/cms/s/0/3722d4a0-0a63-11e5-82e4-00144feabd...](http://www.ft.com/cms/s/0/3722d4a0-0a63-11e5-82e4-00144feabdc0.html)

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PaulHoule
That is the least of things to worry about.

Talk to any face to face financial advisor and they will tell you to buy bonds
not bond funds. (You never hear this in the financial press, funny...). The
issue is that bond funds don't behave much at all like bonds do because they
are always trading to keep the maturity distribution constant. This in turn
throws off the logic behind the idea that at age X you should have Y percent
of bonds and Z percent of stocks.

If you are doing the "put $50 a week in your IRA" thing, you can't even buy
bonds because the denominations are way too large period, but it is even worse
if you want diversity.

I'd love to see some kind of ETF with an expiration date that would behave
like a bond, give diversity against default risk and be denominated to be a
tool for the ordinary investor.

Trouble is it is hard to get anybody excited about bonds today and if interest
rates ever go up, bond funds will be a bloodbath -- PIMCO will lose more money
for investors than anyone in history, not because they did anything wrong but
just because that is how the cookie crumbles.

With that backdrop it might be 25 years before people will buy a new debt
product.

~~~
marko2525
This is not correct. What you're referring to is holding a bond to maturity
versus holding a bond fund. If rates were to rise, both would be (relatively)
equally affected. The difference would be that the price of the bond would
revert to the face value of the bond as it got closer to maturity.

Obviously the downside of this is that you are basically keeping your
principal value at the end of the day, but you're forced to hold a bond that's
giving you a below market return until it matures. For most people, this makes
absolutely no sense.

On top of that, you can buy and sell a mutual fund based on the asset value of
the fund at any time, while the bond market is opaque and you often get
pricing that is very far off the average unless you are a large institutional
buyer/seller. There are massive economies of scale in bonds that you don't see
in the stock market.

If you are trying to invest millions of dollars, buying individual bonds might
make more sense, but at that point you're going to want someone to help you
determine the difference between individual bonds and the covenants that one
bond has over another, but even then you still run the risk of getting bad
pricing on buying those bonds.

~~~
3pt14159
But don't we have extremely straight forward math that can convert bonds into
equivalent terms? If I'm 3 years into my 10 year bond, and the rate changes
the choice isn't hold - not hold, since I'm effectively making the same bet as
if I had the net present value of the partially paid out 10 year bond and I
was evaluating 7 year bonds.

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fitzwatermellow
Another Bloomberg report that sums up the fears spreading through the "bond
market":

Bond Rout Wipes Out 2015 Gains as Traders Stay Glued to Screens

[http://www.bloomberg.com/news/articles/2015-06-03/bond-
rout-...](http://www.bloomberg.com/news/articles/2015-06-03/bond-rout-wipes-
out-15-gains-as-traders-fret-even-leaving-desks)

Bill Gross of Janus called German Bunds the "short of the century" and it
looks as if US and JPY are equally vulnerable. $TLT down 15% since Jan and I
believe it still has room to run on the downside.

Now, interestingly, just this week Gross cited another "short of the century",
calling for a top on Chinese Internet Stocks in the near term. But with
another 25 IPOs coming down the pipeline this one will face a lot of
headwinds. Man, I _heart_ summer volatility...

[http://www.bloomberg.com/news/articles/2015-06-03/gross-s-
ne...](http://www.bloomberg.com/news/articles/2015-06-03/gross-s-next-short-
is-china-s-stock-index-but-not-yet)

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zhte415
A crash in bond prices means an increase in yields.

The article doesn't mention, and acknowledges this, whether treasuries or
corporate bonds are worrying people. If the former it could be back to 'normal
interest rates' (or at least ones that reflect and account for economic
growth), if the latter then another recession, but I think this call is 3
years too early.

The article talks about CDOs and CDSs - the book 'The Big Short' by Michael
Lewis is a good read about CDOs and CDSs in the run-up to the 2007/2008 crash.

~~~
whatok
Both treasury and corporate bond liquidity are worrisome. At least from the
credit perspective, banks were previously able to step in when shit hit the
fan and smooth out market volatility. Between prop desks being dismantled and
increased capital charges, banks are simply no longer warehousing risk.
There's been constant sell-side pieces and more recently a lot of regulatory
or government cautions on the topic.

~~~
nissimk
If interest rates begin to rise, this can really be a serious problem. If
people start liquidating their bond mutual funds and etf's and there is no
liquidity in the underlying bonds, there will be a large dislocation.

But isn't all this rhetoric and fear mongering just here to promote a
continuation of the zero interest rate policy? Japan's been there for 20 years
and we're only at year 8...we've got to maintain zirp forever now. The list of
terrible things that will happen in a rising rates environment is quite long.

~~~
zhte415
The risk of zero rates is greater. Low long term interest rates are bad, as
they represent low (or zero) growth. A sell off in bonds, especially low-risk
bonds such as treasuries, is a move into interest-seeking assets, which is an
appetite for risk. This is a good thing.

The economy is a balance sheet, however simplified or complexified it may be
made. A low return on capital represents a low growth of capital. In some
economies with less transparent capital markets, the link to official interest
rates and actual growth is difficult at best, but in more developed capital
markets the cost of capital is well proxied by the interest rate. And if the
interest rate is low, the return on capital (at a macro level, totaling and
summasing the micro level anecdote - micro level opinions go both ways) is
low, and if that is low, then growth is low.

Extra: Bond price falls indicate a move into risk. This is especially good for
people affected by stock price falls coupled with low interest rates - 401kers
for example, approaching retirement age with money in growth. Interest rates
(higher) make buying annuities a lot more attractive.

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fredkbloggs
The people who worry about liquidity are always the people who bought on
margin or otherwise used short-term debt to finance acquisition of long-term
assets. If I were doing that, I'd be worried too, but it wouldn't matter
whether the overpriced bubbly assets I bought were bonds, equities, artwork,
or tulips.

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fredfoobar42
Isn't the whole point of bonds that they're _not_ highly liquid?

~~~
jpmattia
It turns out: No. You're thinking about it from only one side of the table.

For example: Gov'ts issue bonds on a regular basis to finance their debts.
They depend on that market being there in order to continue normal operations.
If liquidity evaporates, then many participants will not partake in the
auctions, which is A Big Problem. Likely a central bank (a "lender of last
resort") will step in for that case, but that only emphasizes that there are
big market problems to the participants.

~~~
rrggrr
Opposite. Funds will flow to treasury auctions for two reasons. First,
liquidity has to flow and will to the safest destiation; and second, account
surplus countries (eg. China) have to recycle dollars to maintain their
surplus and will have no options apart from treasuries.

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ISL
Seems like the value investors might not be there to take the other side
because they don't see value. If the price moves enough, they'll appear.

