BONDS

Trad­ing cor­po­rate bonds is be­com­ing tougher as banks back away from trad­ing non-govern­ment debt. If “sell” sen­ti­ment rises rapidly for this type of debt, could a bond melt­down re­sult?

Investment Executive - - CONTENTS - BY AN­DREW ALLENTUCK

Re­cent signs from cen­tral bankers and bond mar­kets sug­gest that cor­po­rate bonds’ prices could go into a death spi­ral.

could cor­po­rate bond prices go i nto a death spi­ral? Some re­cent signs from both cen­tral bankers and bond mar­kets sug­gest such a pos­si­bil­ity ex­ists.

With economies re­cov­er­ing in sev­eral coun­tries, cen­tral banks have sig­nalled that al­most a decade of ul­tra-low in­ter­est rates is com­ing to an end, putting down­ward pres­sure on bonds and prob­a­bly end­ing their strong per­for­mance since the fi­nan­cial cri­sis of 2008-09. At the same time, cap­i­tal ad­e­quacy rules put in place af­ter that cri­sis have re­duced the liq­uid­ity of many cor­po­rate bond funds. That has cre­ated fears among al­ready ner­vous bond­hold­ers that a sell­ing trend could turn into a rout, with bond prices fall­ing fur­ther.

Cen­tral banks have had such a melt­down in their sights for months. The Bank of Eng­land is­sued a Fi­nan­cial Sta­bil­ity Pa­per on July 14, ex­plain­ing how bond funds pres­sured by in­vestors might cause a mar­ket melt­down. A sim­i­lar call about the liq­uid­ity is­sue was sounded a month ear­lier by the Fed­eral Re­serve Bank of New York.

The liq­uid­ity is­sue is not new: cor­po­rate bonds are of­ten hard to price and harder to trade. The rea­son is that deal­ers, which tra­di­tion­ally owned the bonds they traded, no longer carry a lot of cor­po­rate bonds in in­ven­tory. Now, a cor­po­rate bond trade is done on a “best ef­forts,” agency ba­sis for the banks. This widens spreads and adds to bond­hold­ers’ risk.

Adding a cor­po­rate bond fiz­zle driven by mar­ket fail­ure, on top of ex­ist­ing liq­uid­ity is­sues, would be some­thing like the mort­gage melt­down of 2008. Banks have been in­su­lated from a re­peat per­for­mance of that event by a host of new rules that re­quire them to back hold­ings of cor­po­rate bonds, any of which can de­fault, with cap­i­tal. The banks’ bal­ance sheets are stronger as a re­sult, but hold­ers of cor­po­rate bonds carry far more trad­ing risk, thus cre­at­ing a drag on bond mar­kets.

Given this re­duc­tion in trad­ing op­por­tu­ni­ties, anx­ious bond­hold­ers may rush to the head of the line when pres­sure to sell be­gins ris­ing. Mak­ing mat­ters worse, ris­ing in­ter­est rates will put pres­sure on bond prices, es­pe­cially those of heav­ily in­debted large is­suers such as util­i­ties. That could be the trig­ger for a bond mar­ket melt­down.

Un­der great duress, the cor­po­rate bond mar­ket could even lock up, says Ed­ward Jong, vice pres­i­dent, fixed-in­come, with TriDelta In­vest­ment Coun­sel Inc. in Toronto. In such a sce­nario, there would be no prices, no trades and nowhere to shift risk.

“There could be a fire sale, but buy­ers ought to come in if is­sues with solid AA rat­ings rise to 4% or 5% from a re­cent 1.84%. Then, we would step in,” says Vivek Verma, vice pres­i­dent at bond in­vest­ment spe­cial­ist Canso In­vest­ment Coun­sel Ltd. in Rich­mond Hill, Ont. “You are com­pen­sated by the yield at pur­chase. Most in­sti­tu­tions would have small weight­ings. You could wait to sell.”

That’s the the­ory. The re­al­ity is dif­fer­ent. On Feb. 23, 2016, Cana­dian Nat­u­ral Re­sources Ltd.’s (CNR) U.S. dol­lar-de­nom­i­nated 3.8% is­sue, due April 2024, spiked to yield 8.49% to ma­tu­rity, which was 669 ba­sis points (bps) over the U.S. trea­sury bond that paid 1.8% on that day.

“It was rare for a well-known name to go beg­ging. But, on that date, all en­ergy bonds were sell­ing off. It looked like a fire sale,” re­calls Chris Kresic, part­ner and head of fixed-in­come with Jaris­lowsky Fraser Ltd. in Toronto.

The bond was in trou­ble be­cause oil prices had sagged be­low US$30 that day, he adds. The con­sen­sus was that sell­ing oil bonds was a good strat­egy; the bond’s price re­flected that. The is­sue’s yield then tum­bled in fol­low­ing weeks to 3.55% at the be­gin­ning of Au­gust, as oil prices and bond mar­ket con­fi­dence re­cov­ered.

There are other risks that could lead to a bonds fire sale. A great deal of cor­po­rate debt was is­sued dur­ing the pe­riod of low in­ter­est rates, if only to fi­nance eq­uity buy­backs, Kresic ex­plains. That boosted lever­age.

Other fac­tors: the in­vest­ment com­mu­nity buy­ing a lot of debt; and so much of the re­tail com­mu­nity has bought pas­sive debt through in­dex funds.

“When bonds are i n in­dex funds, which have blos­somed to hold mas­sive amounts of debt, it is the gen­eral mood rather than bond qual­ity or price that moves the mar­ket,” Kresic ex­plains.

Is the bond mar­ket pric­ing in the cor­rect liq­uid­ity risk now, Kresic asks. In­vest­ment-grade spreads were as tight as 50 bps over gov­ern­ments of the same term be­fore the fi­nan­cial cri­sis.

Now, in­vestors should de­mand pre­mi­ums of more than 50 bps — per­haps 100 bps, which in­cludes the po­ten­tial fire sale — for tak­ing on liq­uid­ity risk. Also, com­pared with 10 years ago, credit qual­ity is weaker, so in­vest­ment-grade bonds out­stand­ing tend to be one notch lower than in 2008.

For pas­sive bond­hold­ers, risks may in­clude re­main­ing un­com­pen­sated for lower qual­ity and lower re­turns.

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