Bank of America; "This Could Get Ugly, We Think"

Instead of finding new and creative ways of BTFD, overnight the BofA credit team did something so few finance professionals bother with these days: they looked at fundamental data to reach a conclusion that is independent of how much AAPL stock the SNB will have to buy to send the Dow Jones green. Specifically, the bank looked at the liquidity situation in the bond market (specifically the IG space), and found that while for the time being there is little to worry about, once the central bank put melts away, that's when the real test will take place. And, as BofA puts it bluntly, "this could get ugly, we think."

As the bank's credit strategist Hans Mikkelsen explains, high grade corporate bond trading has doubled over the post-crisis years (Figure 1). However, as the size of the market tripled that means the overall market has become less liquid due to a number of post-crisis changes, including financial regulation and most prominently the Volcker Rule, but also less leverage in the system. For example, while annual trading volumes in the HG corporate bond market were 135% of the size of the market back in 2006, that same tracking statistic is only 86% for 2017 (figure 2).

And yet, according to Mikkelsen, despite the top-level implication that liquidity in this environment should be declining, "market-based measures of liquidity - such as off-the-run/on-the-run spread premiums are back to pre-crisis levels." He then adds that "this is true for bid/ask spreads as well, although we are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds."

Moreover quality data on bids and asks naturally is concentrated in what is liquid and trades. In contrast liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders.

We imagine Mikkelsen made the explicit reference to bid-ask spreads, because just three weeks ago, an analysis by his European colleague Barnaby Martin, found that the bond market is increasingly illiquid along this metric, and especially in the euro high yield market, where bid-offer spreads have blown out in the past 4 years. Quote Martin:

We find that even though the average bid/offer cost (in absolute spread terms) has declined as broader market spreads have compressed, the b/o cost per unit of spread has been increasing consistently in recent years. Also, despite the broader market (HE00) trading at the tightest levels in a decade, trading costs are still higher.

But let's assume Mikkelsen is right, especially since his ultimate point reaches the same conclusion as Martin. According to the BofA credit strategist, market based measures are back to pre-crisis levels "because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds."

In recent years, yields have dropped so much that investors have been forced to enhance yields by reaching into normally illiquid off-the-run names and maturities, which naturally compresses the off-the-run/on-the-run liquidity measures. That means liquidity is OK because dealers are happy to use their lean balance sheets to not only buy liquid on-the-runs that turn over quickly, but also normally illiquid off-the-runs because there is an army of investors waiting to buy them in short order.

And here a paradox emerges, because BofA finds that while regulation may have tried to limit the liquidity of various risky markets, the record balance sheets of the world's central banks have offset this regulatory endeavour, or as Mikkelsen writes, "in other words, in the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market."

To gauge his assumptions, Mikkelsen provides an empirical test of evaluating On/Off the run bond market liquidity, a proxy for overall credit liquidity. The chart below shows the bank's preferred measure of market liquidity - the percentage difference between credit spreads on 9-year and 10-year bonds (adjusted for the on-the-run curve).

"The idea is that on-the-run 10-year bonds are issued and traded actively and are liquid. Then liquidity declines over time and they become off-the-runs. We use the 9-year maturity point for that, as the bonds have not become too illiquid for pricing to be somewhat accurate."

Mikkelsen next plots the liquidity premium over time against interest rates to show the normal environment, which we saw for example around the US downgrade and European sovereign crisis in 2011, where there was an inverse relation. In such risk-off environment, Treasuries rally and liquidity dries up. But fast forward and starting in 2015, there has been a strong positive correlation between interest rates and the liquidity premium.

"The reason for this shift is very simple - as we described above - that interest rates had declined so much that further declines force investors to reach for yield in off-the-runs, while with increasing rates they are able to return to on-the-runs. Hence, the big decline in interest rates has compressed the liquidity premium to pre-crisis levels"

Which brings us to BofA's amusing observation, namely that "this means everything is OK until it is not" which come to think of it, is a perfect summary of everything else that is broken with both the centrally-planned market and the centrally-planned economy. But when does it become "until it is not" time? As BofA suggests, "only when interest rates go up significantly, and we get large outflows, will we see just how illiquid the corporate bond market can be in the new regulatory regime. Initially liquid names and maturities would likely underperform as investors have to sell what they can. Then later when investors find they can no longer sell the vast majority of bonds they own - the off-the-runs - at meaningful prices we get a big widening in liquidity measures."

Mikkelsen's conclusion: "this could get ugly, we think" which, of course, is a polite euphemism for marketwide crash.

And while nobody doubts that in the longer-run that is the correct conclusion, perhaps someone can also explain not what but when it will happen.