Towers Watson: Tight Corporate Bond Market the ‘New Normal’

With inventories of corporate bonds at the lowest point in a decade, Towers Watson foresees sustained illiquidity and heightened volatility ahead for the fixed-income market.

(September 6, 2012) – Liquidity has dried up in the corporate bond market, and Towers Watson analysts expect the drought to continue.

“Liquidity is very patchy and confined to the top 100 or so names,” Towers Watson concluded from a January survey of fixed-income managers. “In other words, about 90% of the long end is materially illiquid. We find that bonds issued more than a year ago also suffer severe illiquidity, and even among newer bonds, liquidity does not extend to smaller issues.”

Institutional investors can expect heightened volatility in the fixed-income market, with little liquidity to buffer inventories and overall spread levels from market forces. Long duration bonds are particularly vulnerable to credit market trends, and may be a segment with even less liquidity than corporate fixed-income as a whole. Defined benefit plans, the main investors in high-quality long bonds, are “generally believed to be slower in implementing major allocations into and out of fixed income,” the authors wrote. “At the same time, because the spread duration can be relatively large for a long-duration credit, from a risk mitigation standpoint, it is quite possible that dealer inventories are even lighter on the long end of the credit curve.”

Primary dealer inventories of corporate bonds are at the lowest point since early 2002, according to data from the New York Federal Reserve. Furthermore, the amount of outstanding corporate debt has more than doubled since that time. Proportionally, bond dealers’ shelves are barer now than they’ve been in a very long time. Inventories dropped by half in just seven months, between the end of May 2011 and the close of January 2011. Many managers surveyed cited new regulation—Basel III and the Volcker Rule—as the catalyst for this dramatic decline.

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“Corporate bonds trade over the counter in an extremely fragmented market,” said the Towers Watson report. “It is not surprising that lower dealer inventories have negatively impacted liquidity in the high-grade and high-yield markets, which, in turn, has caused an increase in bid/ask spreads.” According to the whitepaper, an internal BlackRock study found that investment-grade bid/ask spreads increased roughly 40% from 2007 to 2011.

The precipitous decline in inventory in the latter half of 2011 left its imprint on the market. The fourth quarter of 2011 posted the lowest average daily bond trading volumes since the onset of the credit crunch in mid-2008, just breaking $10 billion per day in December. Trades have rallied since then, averaging about $15 billion per day in April.

“Most managers seem to be of the opinion that while total market activity improved in Q1 2012, the overall breadth of liquidity in the credit markets still remains challenging,” the research and consultancy firm asserted. “The pullback in support by the dealer community in terms of inventory has an impact on all credit markets.”

(September 11, 2012) – Sophisticated investors can be seduced by the same risk-return fallacies as lottery ticket customers, argues Societe Generale investment analyst Dylan Grice.

“The same psychological tendency that overvalues lottery tickets undervalues quality stocks, as their robust business models and solid balance sheets do tend to be quite boring,” writes Grice in his blog Popular Delusions. “So our best guess at the moment is that the mispricing of quality is indeed systematic. It reflects something permanent (our psychological hardwiring) rather than something transient (the fads of macroeconomic theory).”

After pouring through decades of stock market data, Grice and his colleagues found a persistant pattern: On average, returns from high risk investments don’t compensate for the risk an investor takes on. Conversely, very low risk equities tend to pay off disproportionally well.

Statistical reasoning is like a magnetic compass: When probabilities approach polarity–if an outcome is extremely unlikely or near-certain–our perception of risk goes haywire, he argues. That’s why people buy lottery tickets and penny stocks, despite the outsized chance of losing their investment.

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In Grice’s view, people value certainty so highly—100% is vastly more comfortable than 95%—that near-certainty can be had for cheap: “We undervalue near-certain outcomes. Yet this is exactly the world in which low beta/high quality stocks live…And if high beta/low quality stocks live in the world of possible triple-digit returns, attracting lottery ticket overvaluations, low beta/high quality stocks live in the world of near certainty, attracting the boredom discount.”

This theory dovetails with the low-volatility investment anomaly: “All ‘true’ low volatility portfolios should earn a premium return of about 2% in the United States and do so with 25% less absolute risk than the benchmark,” says one leading strategist. “Even something as simple as screening out high volatility stocks and weighting by the inverse of volatility (i.e., allocating more to low volatility stocks) will produce a comparable result.”

While penny-stock traders pay a premium for the thrill of a slim chance, what’s the converse—the psychological effect of near-certainty that investors are eager to buy their way out of? “Slightly anxious boredom,” says Grice.

Read Grice’s whole paper here.