Blain’s Morning Porridge – April 9th 2019 – Liquidity?

Blain’s Morning Porridge  – April 9th  2019

“Ashley Giles trundles in to bowl rather like a wheelie bin..   ”

In the headlines this morning: https://morningporridge.com/stuff-im-watching

What an interesting morning…

 

  • Trump opens delicate trade negotiations with Europe by threating $11 billion of new tariffs on everything from Cheese to Helicopters. Nice – we’re now familiar with El Donald’s approach.. The man is simply an Oik.
  • Goldman Sachs earns a “No Sh*T Sherlock” award for pointing out how $420 bln of stock buybacks has been driving the market for the last decade. NSS! They might add that funding these buybacks by overleveraging in the bond markets isn’t that positive either.
  • Oil on something on a roll on back of Libya crisis and Trump roiling the Iranians.
  • Aramco bond deal attract $85 bln in orders… skewed towards long end.. (Trying to get my head around it..)
  • Brexit still in the balance. Theresa May holds the UK parliamentary record for upsetting the largest number of parliamentarians since Charles the 1st. While most analysts expect the UK to be rewarded for agreeing absolutely nothing by granting us a deadline extension – which, of course is what Yoorp really wants so we eventually give up and vote the right way to remain – but there is a small risk a short-statured Frenchman will pull the plug. History has a tendency to repeat itself.. again, and again…

 

As always the devil will be in the detail…

But, the really shocking news this morning is I’m willing to admit I might have been wrong about something.

I’ve repeatedly highlighted illiquidity as the biggest risk facing markets. I’ve written many times on how regulation has killed dealer liquidity, the death of market making, the susceptibility of a one-way market to seizing up, the risks inherent in Fixed-Income ETF unwinds, and how the whole market is basically agency-dealer with intermediaries simply trying to match trades. Concurrently, skill and talent has vanished from the investment game – try finding a 25 year bond salesman who understands the complexity of markets. They will bid you low, and mutter about low interest rates mean everyone is chasing incremental yield, but your corporate bond portfolio spread does not correctly price the risk of liquidity trending towards zero. Ask for an offer, and it’s a completely different story…

However, maybe I’ve been wrong? Maybe liquidity is not the problem? Maybe it’s a misunderstanding of volatility?

A fascinating comment on M&G’s Bond Vigilantes Websiteexamines the numbers: everyone is aware dealer inventor has fallen from $200mm towards $20mm today – a 90% decline, and assumed that’s a clear signal of the end of liquidity and a sound reason for higher corporate bond risk premia. But, the article goes on to explain how banks are making their capital committed to dealer inventory work much harder: Over the last 13 years, turnover in the IG corporate bond markets has more than doubled, while dealer inventories are being turned over 16x faster than in 2007 (a number arrived at by dividing trading volumes by dealer inventory). The gist of the numbers suggests these factors should more than compensate for the perceived drop in dealer inventories.

The M&G article is in direct contrast to recent notes from investment banks highlighting the risks of illiquidity in corporate bonds. UBS said liquidity into selloffs and rallies are made worse by herd mentality. Bid/offer spreads on high yield bonds widened dramatically as the market tumbled ahead year-end last year. Deutsche Bank went further, arguing increasing defaults, regulation, illiquidity and concentration in fund structures will trigger a corporate bond meltdown. (I’ve attached links to stories on the Morning Porridge Stuff I’m Watching Webpage.)

Speaking to clients some very interesting perspectives on the liquidity debate came up.

i) Many portfolio managers suspect CROs (chief risk officers) and compliance over-obsess about liquidity because liquidity rules are now written into investment guidelines and regulations.

ii) In “doom and gloom markets” the background rules create a behavioural bias to over-emphasise liquidity risks – because investors are repeatedly told it’s the major risk.

iii) Recent bear market comments from banks have played up and fuelled liquidity risk fears in the minds of investors.

iv) The reality is a bid is a bid is still a bid on any decent fixed income asset. Even in poor markets there are likely to be distressed buyers even for complex assets. There is also a price for distressed assets. The key is price discovery where that price will be volatile. The trick is spotting such opportunities to buy cheap!

v) There is nothing to be scared about in terms of volatility – its critical allowing smart investors not to time the market (which is a sure-fire way to lose money), but to spot the right opportunities to buy and sell.

vi) Certain “complex” areas of the market – such as bank capital or EM can be subject to periodic lockdown as idiosyncratic risks such as a raised bail-in threat, a capital event or political event risk. Deal with it.

vii) The deeper yield tourists climb up the risk mountain, for instance from high-grade into high-yield, the thinner liquidity (as measured by bid-offers) is likely to become.

viii) The trick is to be methodical, strategic and clear – manic investors seized by perma-disaster/bear scenarios tends to be holders who lose money.

ix) The increase in market turnover on the M&G charts is pretty much due to increased new issue trading.

It’s also a matter of tactics; my colleagues at Rubric – Shard’s credit fund – point out the evidence on bid/offer vs size: LQA on Bberg shows the larger the block size, the bigger the market concession. In other words, small and diverse rather than big and discrete might work better where prices look illiquid. (Their very successful credit fund achieves above market returns – happy to introduce you to them so they can explain how!)

What’s the solution and how can I help?

I think a fundamental acknowledgement that liquidity is more a concept, an excuse, and a regulatory/compliance crutch than a market reality might help. There are times when finding a bid or offer is difficult in the bond market – but that’s as much a function of it being a market comprising of many, many discrete small instruments held by a multitude of players, and the small number of intermediaries who actually understand the complexity of what they are asked to trade. After 35 years in fixed income, I may be an old dog, but I know what works..

It’s become very easy for investment chiefs to glance at liquidity and order their teams to avoid illiquid instruments, using “illiquidity” as an excuse rather than a function of the investment decision. That call misses the moment when “illiquidity” and volatility creates opportunities.

Volatility is a good thing.

One trick is finding the right intermediary who understands their market – in my case, my speciality is dealing with the “special situation” investment teams who invest in complex asset backed, equity/mezz/senior debt structures in the “alternatives” space.  It’s maybe time I get back to using my knowledge of areas such as the aviation space – if anyone is looking for ideas or to trade in aviation linked bonds and we’re not already talking, maybe its time we did!

Finally, a complaint.

She-who-is-now-Mrs-Blain and I have been using a App called Calm. It may sound silly, but listening to a bed-time story is a great way to fall deeply asleep. The anodyne gently read tale of the Earth viewed from outer space, a train trip to Cornwall, or a discussion of giant redwoods in California leaves me asleep in moments.

Until last night. I made the mistake of listening to Henry Blofeld’s short story explaining cricket. It was so interesting I couldn’t sleep for hours. Calm will be receiving a VAL (Very Angry Letter) and I’ll be buying Blofeld’s book to read on the flight to Australia later this week.

Out of time and back to the day job..

Bill Blain

Shard