Adam Vengrow Comments: Higher Volatility and Less Liquidity: New Normal In Loan Market
January 28, 2012, Reuters
Increased volatility has become the new normal for credit investors, as liquidity seeps out of the secondary markets. Portfolio managers will likely face heightened premiums for actively traded papers as well as increased transaction costs, leading to less trading overall.
The interplay between volatility and liquidity is strong; one pulls and tugs at the other. At the moment, the give and take has resulted in gyrating prices and low trading volumes in credit markets. Uncertain macroeconomic conditions - with Europe playing a starring role - combined with coming financial regulations promise more of the same.
"There will be permanently more volatility than there was pre-2006," said David Frey, managing director at Highbridge Principal Strategies, about the loan secondary market. "Less liquidity - that's the reality that we live in," said another investor.
Liquidity has indeed dropped. The value of Barclays U.S. high yield indices has grown 53 percent since 2006, while TRACE volumes retreated by 9 percent during that time, cited Barclays Capital in a December 2011 report. For leveraged loans, trading volumes declined in 2011 to $409 billion, with each consecutive quarter of the year showing less paper trading hands, according to the LSTA.
And while the global outlook will change, new regulations may keep liquidity down for the count. Based on reporting to the Federal Reserve, broker-dealers drastically shed corporate bond inventory last year. Dealers now hold a smaller percentage of the overall corporate market than at any point in the last decade, according to Barclays Capital, which attributed the shift to the Basel III and the Volcker Rule proposals.
"Before dealer liquidity provided cushion and insulation against volatility in the markets," said Jason Rosiak, head of portfolio management at Pacific Asset Management. "In a less liquid environment, you lose the cushion."
Thus, price changes could be amplified, up and down. Investor sentiments, as tracked by fund flows, could be exaggerated.
"Technicals in either side will be overemphasized," said Adam Vengrow, co-head of credit sales and trading at Cantor Fitzgerald.
With the ease of buying and selling securities hampered, investors will look for a liquidity premium, with harsher pricing extracted at the lower end of the rating spectrum and for smaller companies. A SIFMA and Oliver Wyman study estimates that a liquidity premium for a high yield bonds in the fortieth percentile liquidity is 72bp higher than that at the fiftieth percentile, or median, liquidity. That impact will be exaggerated in thinner and bespoke markets such as the one for leveraged loans. One loan investor calculated that the secondary market may ask for about a quarter of the middle market's roughly 1.88 percent yield premium.
"In general, when there are periods of reduced liquidity, investors look for a liquidity premium. This cost is ultimately passed on to issuers," said David Weiss, head of leveraged finance trading at BMO Capital Markets. That could be as higher as $90 billion to $315 billion value loss for existing U.S. corporate bonds and $12 billion to $43 billion yearly for corporate issuers from the Volcker Rule alone, reckons SIFMA and Oliver Wyman.
Besides paying more handsomely for liquidity, investors will also have to take more care with their portfolio selection. Since exiting out of a position will be harder going forward, greater weight will be given to how credits can weather a downturn. And timing and the depth of inventory become more critical factors when entering and exiting a credit.
The higher costs of transactions will also have an impact, dampening active trading and adding incentive to position right the first time. For corporate bonds overall, reduced liquidity could hike transaction costs $1.3 billion to $3.9 billion for the $3.3 trillion customer-to-dealer trades a year. For the loan market, which has traditionally had a far wider bid-ask spread, the additional cost could hurt more. Already, the bid-ask spread for the overall loan market, which spiked in August, has kept at 65 percent higher to 1.44 percent. The bid-ask spread difference between the most widely held loans and the overall market has widened from 0.25 percent to 0.6 percent.
For the institutional loan market, the heightened volatility also comes from the swapping of new investors such as mutual funds for CLOs. As fast money becomes bigger players, the need to hold a greater number of liquid names in a portfolio increases.
But there is an upside to volatility. "Personally I like volatility," said Frey. "You can generate more alpha."
