An Answer To Bond Market Illiquidity

by: Kurt Dew

Summary

The market for short-term credit has been largely reduced to a single maturity – overnight.

Uncomfortable, since the reason is loss of faith in the safety of major banks.

Commercial banks are in eclipse, being replaced by shadow banks.

But it is possible for finance to rise from the ashes – to turn this crisis to our advantage.

Beginning by dumping the bond market.

"I thought I knew you, What did I know? You don't look diff'rent, but you have changed. I'm looking through you. You're not the same."

- The Beatles.

Suddenly, it’s all overnight, all the time! That’s the new reality of the money markets. Longer-dated short-term credit markets have mostly dried up – producing the side effect that LIBOR, the short-term rate that’s still the pricing basis of the world’s largest financial futures market, as well as several hundred trillion in credit assets and over-the-counter derivatives, is a myth. And the government, observing the move among financial institutions from LIBOR to overnight, has accelerated the movement to overnight by proposing to replace LIBOR with the Secured Overnight Financing Rate (SOFR, an overnight repo rate of governmental construction.)

But LIBOR's use as a pricing index rolls on. Financiers don’t seem to mind that the daily-reported number is imaginary. There have been more LIBOR sightings than sightings of aliens, Elvis, and Sasquatch combined. The continued routine use of LIBOR is a tribute to the human imagination.

However, in banking and regulatory circles, there is much hand-wringing since the spot short-term money markets dried up. The end of a way of life, really. But I have reconsidered the new overnight world.

Good news! If the markets embrace overnight funding on a permanent basis, this new overnightedness, to my amazement, produces a baseline for credit market reform and renewal.

For example, the old-fashioned, complicated, obscure, information-intensive issuance of corporate bonds can be replaced. Instead of the complex current bond market – a bazillion, obscure, illiquid bonds that are the play-toys of hedge funds and bond salespersons – the bond market could be replaced by a liquid, buyer-friendly, market-priced, bond market – consisting of only a few active, market-priced, user-friendly issues.

The bad news: there seems to be nobody willing to get the job done. The buy-side is the primary beneficiary of this change, along with their investor/customers. Sadly, the buy-side is as aggressive in pursuing its own self-interest as a two-toed sloth. They cannot be counted upon to take advantage of this opportunity. I do not understand buy-side lethargy.

The up-side of overnight.

Although reliance on the overnight market for short-term financing was not the first choice of anyone, the Financial Crisis-bred lack of confidence in the near-term future of financial institutions, coupled with the growth of money market fund sourcing of credit by the ever-expanding non-bank financial institutions, has created that effect. It’s time to deal with it.

The upside of all this overnightedness is simplicity. There are only two versions of the overnight market – commercial paper and repurchase agreements. Overnight rates are high volume sources of reliable market valuations. Let’s make the most of it. How? Trash the other fixed income markets! Opt for simplicity.

Trashing the bond markets.

Why tolerate the messy current bond market? The bond market exists in its current form because corporations ask sell-side investment bankers what to do when they seek to borrow long-term money. An investment banker’s answer, always and everywhere, has to do with maximizing investment banker income. That is, after all, their primary responsibility. And you only need an investment banker when you have a complicated problem. Complication builds investment banking profits. Ergo, the bond market is complicated.

On the issue side, bonds produce investment banker fees, underwriting spreads, and derivatives trades. On the sell-side, there is commission revenue and investment advisory fees. For broker/dealers, bonds are the mother lode. But for broker-dealer customers, both the corporate world and the buy-side, bonds are a poor way to pass value back and forth.

A simpler system would minimize the operating costs of funding corporate long-term debt. It would be far more flexible, allowing corporations and investors to adjust their maturity configurations as easily as flipping a switch. And the corporate cost of credit risk would be more easily separated from the corporate cost of maturity transformation.

The key to simplification of long-term finance is the separation of the pricing of individual corporate credit risk from the pricing of maturity transformation. Separating the two issues would make the pricing of corporate credit risk specific to each corporation, as it should be. The current situation is that bond credit risk is not simply a question of the borrower's risk, but also varies from one bond to the next, for a single corporation. If credit risk were the same for all debt of each issuer, credit risk and maturity risk would be easier to evaluate. The bankruptcy process would be enormously simplified.

Then term adjustment could be a simple matter of maturity transformation with a single generic instrument. There is no reason, other than bad financial practice, for maturity transformation to cost more for one firm than another.

Making overnight a good thing.

There are two characteristics of overnight money that make it useful. Overnight doesn’t dillydally. And price differentials among alternative overnight investments are simply a reflection of risk differentials.

Credit markets are fickle.

First, overnight doesn’t hang around and get seasoned. It’s gone the next day. Term debt, on the other hand, once issued, leaves the market with a hangover. There is an annoying tendency for 3-month money – or any other liquid maturity – to become 2-month 29-day money. Nobody cares about odd-dated fixed instruments like that, so they sit around untraded, illiquid, unpriced. If 2-month 29-, 28-day, etc. debt had some useful function, I wouldn't complain. But to fickle traders, only a few maturities are of interest. Yesterday’s 30-day money is cast off like an old flame.

So, why not dump most investment into the overnight maturity, using contingent claims to extend its risk profile to a longer maturity if desirable? Leave investors the option to convert overnight money to more distant maturities, but also the possibility of modifying the price risk of overnight money to that of a bond without altering its maturity directly.

Those who buy 5-year money because they need to prevent themselves from touching their funds for another 5 years can do so. But the majority, who might change their minds, could use easily reversed contingent claims. That way an old contingent claim can simply be offset, traded in for a new model. The need for a financial mathematician to figure out how to change maturities, as in the current messy bond market, is wasteful.

Maturity transfer need not involve the credit risk the textbooks assume.

Occasionally, economists enshrine an inconvenient shortcoming of financial instruments as economic theory. A prime example is the “liquidity premium.” According to Wikipedia “The reason behind [the liquidity premium] is that short-term securities are less risky compared to long-term rates due to the difference in maturity dates.” If longer-term securities did not become illiquid, with the resulting loss associated with a sale from illiquidity, this contention would make no sense. It is the “locked in” effect of illiquid long-term investments that make them risky.

If instead of acquiring a long-term investment, an investor simply wants a long-term risk profile, a better solution than trading seasoned bonds would be using a liquid contingent claim, that could be reversed, automatically returning the risk profile to overnight. Offsettable contingent claims would put an end to that explanation of the usual condition of an upward-sloping yield curve.

What would the debt market look like?

If corporations did not need term debt to cover their term equity exposure but instead could use a plain vanilla, exchange-traded, contingent claim, the many issues that complicate the bond market could be dispensed with. For example, the pecking order in bankruptcy would go away, since all corporate debt would be overnight. Seniority would go the way of the Dodo. So would legions of bond analysts.

On the buy side of the debt market, the choices would be greatly simplified. The standard issue no-name long-term debt would be low risk, standardized maturities. Custom designed for the needs of pension funds and insurance companies. Investors that want to take credit risk would find all the credit risk they could ever wish for in the overnight market.

The primary advantage of this market organization would be clarity. Risk will not be the result of confusion about contract terms. It will be a productive risk, the assumption of known credit and interest rate risks with known returns, all market priced.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.