Liquidity in the Bond Market

Liquidity in the bond market has been a challenge for well over a decade now. Recent events show that despite the macro environment changing, these liquidity problems show no sign of abating. 

This week the FT ran a long-form piece entitled, “The cracks in the US Treasury bond market.” The recent meltdown in UK gilts exposed the vulnerability of large bond markets, and the article asks if the biggest bond market of them all, the US Treasury market, could survive a wave of selling. While the focus here is on Treasuries, this is a broader problem affecting the corporate and high yield markets as well. 

The bond market is unique. And for the past 14 years, it has been forced to deal with a huge distorting factor.

An unsettling picture

The US Treasury market was hit hard at the start of the pandemic when fears for the global economy precipitated a drop in prices and liquidity. Now a war of two fronts – inflation and looming recession – is leading to more anxiety amongst traders. 

Add in the recent meltdown in the UK LDI market, and you get an altogether unsettling sense that major government bond markets are struggling to cope with the munition being lobbed at them.

Frustrating and problematic 

The SEC has proposed new rules to help the market, including requiring regular traders of Treasuries to register as a “dealer,” which would impost disclosure requirements and higher capital needs. This could affect a range of investors such as hedge funds, high frequency traders, and others that aren’t normally considered “dealers.” 

If the goal is increasing liquidity, this is counterproductive. Higher capital requirements were already imposed on banks and bank trading desks over the past decade, fundamentally shaping the nature of fixed income trading as a result of declining inventory among sell-side trading desks. 

I personally lived through this during my sell-side trading days. Trading in the bond market is not like trading in the equities and futures markets. Your job as a sell side trader is more akin to being an antiques dealer or a used car salesman. Individual bonds don’t trade often or actively, so you need a reasonable amount of inventory to provide liquidity. The more inventory you have, the easier it is for you to put a bid or an offer on something a client wants to sell or buy.

But each line item requires capital. Increasingly onerous capital requirements forced traders to reduce their inventory and their number of line items. Traders went from having books with close to 100 line items down to sometimes less than 10. This makes the bank “safer” … and the trader’s pnl probably less susceptible to large drawdowns. However, it fundamentally changed the behavior of the trader. Market makers went from being willing to provide liquidity on nearly every client enquiry, to responding to most client requests with a “pass,” or a “happy to work an order.”

This is undoubtedly frustrating and problematic for investors. Reducing the number of institutions who can act as market makers is only going to make the problem worse.

Beyond tech

Sadly, despite my belief in the power of technology, it cannot solve this. The problem is fundamentally down to a huge imbalance of supply and demand.

The market is so dominated by central banks now, that anyone trying to trade in the same direction as the central banks is screwed. During the years of QE (turbocharged by the pandemic) the central banks were the biggest buyers around - globally their balance sheets increased from $15T to $24T in just 2020 alone - leaving the rest of the private sector investor base with only crumbs to fight over. At least there continued to be new issue supply, that could regularly satisfy demand.

The macro environment has now turned. Rather than QE, we have QT…quantitative tightening. So central banks are selling, borrowers are continue to issue new supply, and asset managers are rebalancing in advance of higher anticipated interest rates, so are selling as well. With 3 groups of sellers and no buyers, it’s no surprise that liquidity is terrible.

Because there are so many line items, the bond market doesn’t trade continuously in the way that the equity market does. It moves in discontinuous steps, with overnight news resulting in step changes to where the “clearing price” is. Those steps changes are sometimes referred to as “air pockets”, as the entire market sells off (or rallies) without a single trade, before finding a new level where a brave soul is willing to step in and take the other side. 

Technology won’t fundamentally alter the dynamics of supply/demand that drive the market. During QE there was too much demand, not now during QT we need to brace ourselves for too much supply.

An unwritten rule

Central banks seem to have backed themselves into a corner.  It may not be explicitly written into each central bank’s charter, but in addition to “price stability” and “employment,” “orderly markets” are definitely something they are sensitive to.

Cooling inflation (in the US) will provide some relief, reducing the urgency of QT in the US. But the UK is still seeing record high inflation prints so the Bank of England will need to hold its resolve, and start selling.

The LDI pension fund panic shows how difficult the Bank’s job is right now. How they prioritise orderly functioning of the gilt market vs inflation will be interesting to watch.

What does this mean for Issuers?

Issuers need to brace themselves for even more volatile markets, wider new issue premiums, and shorter windows to issue. They’re going to have to be more tactical and thoughtful about when to come to market.

One thing’s for sure – next year is going to be another interesting year for the bond market!