Picture this: The bond market gets spooked by a sudden interest rate scare, sending a throng of buyers streaming toward the exits, only to find a dearth of buyers on the other side.
As a result, liquidity evaporates, yields soar, and the U.S. finds itself smack in the middle of another debt crisis no one saw coming.
It's a scenario that TABB Group fixed income head Anthony J. Perrotta believes is not all that far-fetched, considering the market had what could be considered a sneak preview in May 2013. That was the "taper tantrum," which saw yields spike and stocks sell off after then-Federal Reserve Chairman Ben Bernanke made remarks that the market construed as indicating rates would rise sooner than expected. (The "taper" referred to Bernanke's statement that the Fed would soon begin unwinding its open-ended monthly bond-buying program.)
The market calmed down shortly after, but Perrotta, writing in the TABB Forum, an invitation-only site for market analysis, thinks the die has been cast for an uncertain future, particularly if the market gets antsy over the future of rates:
(T)he fear is that the committed posture of the U.S. government may provide the impetus for a doomsday scenario in credit markets. While the market focuses so intently on the reasons to keep rates low, it may be blinded to the problem brewing just underneath the surface—the structural imbalance that is developing as the size of price takers (bond fund managers) grossly dwarfs traditional price makers (dealers).
We saw the imbalance this summer, when global unrest caused sudden outflows from high-yield corporates, and last spring, when a swift, but not unprecedented, move in rates caused a negative knee-jerk reaction in credit spreads. As one trader put it: "The Taper Tantrum was the 30-second preview to a full feature film that might yet play out."
At the heart of the scenario is a bond market in which buyers have been plentiful, injecting $80 billion into the market this year alone, but one in which selling those positions hasn't been as easy.
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Perrotta points out that large bond trades—more than $25 million in notional value—have declined 23 percent since 2008, and average trade size for "round lots"—trades divisible by 100—have declined 15 percent over that period.
The fear, then, is that in an exodus for the door along the same lines as the "taper tantrum," or some other unforeseen event, a lack of liquidity in the form of a buyer strike could crush the market:
The movie metaphor is relevant on two counts. First, investors have been flocking to corporate bonds like fans lining up for the next summer blockbuster. Second, a crowded theater is no place to be when Mrs. O'Leary's cow starts a fire. Was June's swoon a prequel to an even greater show, one that starts with a fire and ends up with a simultaneous rush for the exits?
Perrotta's scenario carries the requisite caveats: He said the current state of the credit markets is stable as the U.S. government is "all in when it comes to the need for maintaining low normal interest rates," and the economy is improving.
However, he cautioned that the concentration of corporate bonds in the hands of an increasingly shrinking pool of players poses a liquidity risk in times of turmoil. After all, fixed income experts have been warning of a bear market for years, and if that time finally comes, current market structure may not be able to handle it.
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Perrotta poses several questions that he believes could lead to the doomsday scenario:
In June 2013, global corporate bond portfolios experienced -4.8 percent returns, on average. Asset managers stepped in to buy at wider spreads, putting some of the excess cash they had to work. Many are waiting for another pullback to buy, but what happens if the selling doesn't abate? What happens if the net inflows brought about by years of an accommodative Fed policy turn into outflows and redemptions? What happens when low coupon bonds issued over the past several years start seeing declining dollar prices and returns slip into negative double digits? What happens when the corporate bond spring, which has been coiled so tight, suddenly decides it needs a pressure release?
The prediction of an impending liquidity crisis in the credit markets is not new; people have been envisioning it for some time. The boogeyman under the corporate bond bed may never rear his head; but if he does, he'll do more than just frighten us.
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