A recurring theme we have covered here over the past few weeks and months (most recently here), is that while stocks have soared since the September lows (first on bad payrolls news suggesting no rate hike, then on a Fed hint a rate hike is imminent, go figure), most other asset classes have ignored the furious rally, and none other more so than junk bonds and ETFs.
This is shown both longer-term:
As well as recently:
And it's decoupling in the leveraged loan segment too:
And risk is perceived notably "differently" across equity and credit markets:
That is happening even as the yield curve has furiously pancaked, suggesting the Fed is about to commit a major policy error.
But that's the topic of another post.
For now, we are looking at the one asset class which according to Carl Icahn (who is famously quite short said asset class) remains the canary in the liquidity coalmine, namly junk bonds.
It is here where according to the latest analysis by Citi's Stephen Antczak things are going from bad to worse, not only in terms of underlying fundamentals (recall that as we showed a week ago, corporate leverage is at record high just as corporate cash flows are declining), but in terms of underlying market liquidity.
In fact, for October Citi calculates that the spread between an illiquid and a liquid junk bond portfolio soared to just shy of 100 bps, the highest in this series' history, and double the average of 48 bps. Presenting the infamous "Figure 4":
Liquidity premiums can be meaningful: In the current environment illiquid bonds can offer a sigificant spread premium to more liquid bonds. To illustrate, we created two HY portfolios, one comprised of 100 liquid issues and the other comprised of 100 illiquid bonds. We chose bonds to minimize rating, sector, and maturity differences (and note that we did not include any triple-C, energy, and basic materials CUSIPs, where factors such as potential recovery values may drive valuations more than liquidity).
In Figure 4 we present the spread differences between the two buckets since April, and we see that on average the liquidity premium is 48 bp in HY. We see a significant premium in IG as well (Also noteworthy is that, for both markets, the premium tends to fluctuate dramatically).
For those who have a tough time visualizing the real liquidity in the market, think 80/20, or rather 90/10 - 10% of all bonds account for 90% of the trades with an asymptotic distribution.
Quote Citi: "in Figure 5 we plot the total number of block size trades over the past 3 months by CUSIP in the IG market, sorted from least traded to most traded. We see that the incremental number of trades by CUSIP is quite modest for most issues, but the gap is much, much larger for the most actively traded portion of the market. It’s a small number of bonds that really helps one to behave tactically."
In other words, if one is long any of the names that comprise 90% of the entire bond market CUSIP universe, good luck liquidating if and when you have to, and good luck hoping to "eat" only a 100 bps spread in pricing, especially if and when the market goes bidless.
But will the junk bond, or any other markets, go bidless as a result of plunging liquidity?
That was the question posed at the Reuters Global Investment Outlook Summit in New York. Here is what the participants said, courtesy of Reuters:
"The reason why volatility is going to be higher ... you don't have this huge blanket of liquidity in the world like you had for the last three or four years," said Rick Rieder, chief investment officer of fundamental fixed income for BlackRock, which manages $4.5 trillion.
Rieder noted that currency reserves in China were declining after several years of a reserve buildup in the world's second-biggest economy that had resulted in money entering the U.S. financial markets in "huge size."
Scarce liquidity, partly as a result of curbs on banks' ability to take risks and an increase in technology-driven trading, has contributed to events such as the Dow Jones industrial average losing more than 1,000 points in the first few minutes of trading on Aug. 24 and the Treasury market "flash crash" on Oct. 15, 2014."
There is just not as much two-way flow in the markets as we saw pre-crisis, and I don't think that's getting better in 2016," said Erin Browne, portfolio manager at Point72 Asset Management. "Particularly where the Fed's going to be raising rates, there is less liquidity in the market, there is the opportunity for more gap risk next year," she said in reference to the risk of sudden declines in prices, and with it, sharp widening in bid-ask spreads.
And if SAC, pardon "Point72" is worried about liquidity risk, well... that means that Citi's "Figure 4" is about to get much worse.
So what is one to do? According to Mohamed el-Erian, prayer to the Fed works: the same Fed which is about to take away the liquidity...
Some investors remain under the illusion that the Fed is going to reassure markets during periods of distress, said Mohamed El-Erian, chief economic adviser at Allianz SE.
"The market is comfortable that whenever we hit a hiccup, the Fed is going to come back in," he said. "It's very deeply embedded that central banks are our best friends forever."
He noted that, even though the U.S. central bank "wants to" normalize rates, people have expressed in recent weeks that they still believe that the Fed will engage in another round of quantitative easing. He reiterated, however, that low liquidity remained a risk and that there was a 30 percent probability of a U.S. recession in 2017.
... just to give it right back when the next rerun of the August 24 market-wide flash crash arrives, only this time there is no subsequent rebound and everyone comes crying to Aunt Janet to make it all well again and unleaseh NIRP or QE4, or both.