The last couple of years produced a bumper crop of new corporate bonds as companies raced to market to take advantage of the low interest rates. Amid the heavy new issuance, though, trading of corporate bonds in the secondary market has been declining, a victim of those same low rates and constraints on dealers’ capital.
The state of secondary market liquidity could exacerbate bond market sell-offs as interest rates rise. That might seem to be more of a concern for dealers and investors than for the companies that issue bonds. After all, demand for new corporate bonds remains strong, and getting its debt sold is a company’s main concern.
Some market participants argue, though, that the changes taking place in secondary corporate bond trading will eventually affect issuers as well. Back in May, asset management firm BlackRock, a major buyer of fixed-income securities, put out a paper suggesting that large corporate issuers could give secondary market liquidity a boost if they standardized their bond issuance. “Some standardization seems inevitable,” according to the BlackRock paper.
The shift in secondary market trading is evident in a number of statistics. Alex Sedgwick, head of research at electronic bond trading platform MarketAxess, noted that the turnover rate—the amount of corporate bonds traded as a percentage of the total amount outstanding—has fallen to about 73%, after having been above 120% prior to the financial crisis. “When you start looking at the amount of secondary trading versus the size of the fixed-income universe, it certainly hasn’t kept pace,” Sedgwick said.
Moreover, dealer inventories are down more than 70% from their level before the financial crisis, suggesting bond dealers won’t be performing their traditional function as buffers in future bond sell-offs.
Will Rhode, director of fixed-income research at TABB Group, a capital markets research firm, said the secondary market changes reflect both the increasing cost of bank capital, which caused dealers to reduce their bond positions, as well as other changes that have made participating in the secondary market less profitable for dealers. Rhode cited the shape of the yield curve and low interest rates, which have reduced the profit dealers can make from lending out their bonds in the repo market.
“All these assets are just sitting heavily on their balance sheet, not doing anything,” Rhode said. “And why bother, because all the fixed-income need is being met in the primary market.”
While the decline in secondary market liquidity doesn’t currently pose a problem for companies that sell bonds, that could change, said Sedgwick, pictured at left. “Longer term, once rates rise again, if we continue to see secondary liquidity remain low, then I think you start to see some issues where rates are going to increase for primary issuers.”
Since investors’ interest in new bond issues is partly determined by their view of a bond’s liquidity in the secondary market, “people may be less likely to buy an issue if they think they won’t have the ability to exit that issue if they want to,” Sedgwick said, adding that the lack of a strong secondary market also makes it harder to price new issues. “You don’t have reliable comps to use,” he said.
Sedgwick said both the amount of turnover and secondary market liquidity are related to factors like the size of a bond issue, so liquidity might improve if companies that tend to do smaller issues substituted a larger offering for several smaller issues.
The BlackRock report argued that secondary market liquidity has suffered because there are so many different corporate bonds. It noted that Citigroup has 1,965 different bonds outstanding; Bank of America has 1,544; and General Electric has 1,014. BlackRock suggested that companies issue bonds on a regular schedule, as the U.S. Treasury does, perhaps using maturity dates that match those of centrally cleared swaps, and that they reopen bonds at regular intervals to create larger, more liquid issues.
David Pritchard, a principal at Aequitas Advisors, a capital markets advisory firm, questioned whether standardizing issuance would alter the pattern of declining trading volume as bond issues age.
“Any new issue gravitates into the hands of the people who want to hold it,” Pritchard said. “Even if there was a more scheduled and formulaic method of issuance, you’ll always see bonds trade a lot when first issued, then activity and volume will diminish.”
But Sedgwick sees benefits to standardization: “There’s certainly an argument that if a bunch of companies that are deemed the highest credits and are among the biggest users of capital could do so more efficiently, it would benefit virtually all parties involved,” he said.
At this point, though, companies have little motivation to change the way they issue bonds, as even the BlackRock report acknowledges.
TABB Group’s Rhode, pictured at right, said companies aren’t feeling too concerned about liquidity at the moment given the very strong demand they’re seeing for new issues. Moreover, standardizing issuance “is not practical for them,” he said, noting that corporate finance executives aren’t certain about future cash flows and want to be able to tap the financing markets if and when they need to.
“A lot of CFOs feel that their edge and their ability to add incremental value to the way their business funds itself is by making those calls” on when to issue debt, said Aequitas Advisors’ Pritchard. “A lot of corporations want to preserve that ability to be opportunistic.”
It’s not only issuers that may be unenthusiastic about making changes. Pritchard said more standardization would have a downside for investors as well. If a big company has fewer bond issues outstanding, “an investor’s ability to add alpha by doing more homework and understanding the difference between issue 137 and issue 163 goes away,” he said. Dealer desks also prefer the status quo, Pritchard argued, since a more efficient market means less potential for profit.
Rhode predicted that it would take a significant correction in the bond market for participants to be galvanized to make big changes.
And he argued that it would probably be easier to make changes in the secondary market itself, such as increasing the amount of electronic trading of corporate bonds, than to convince companies to change the way they issue bonds. “The solution to the challenge in the secondary market is within the secondary market itself,” Rhode said.
Read the September Special Report on Liquidity.
Know Thy Banking Partners
Getting a Handle on T&E
Rewriting the Rules: How New Financial Regulations are Expected to Impact Corporate Liquidity Management
The Next Evolution of the US Payments System