Ashley Giles trundles in to bowl
April 9, 2019

Blain's Morning Porridge 

"Ashley Giles trundles in to bowl rather like a wheelie bin... " 

What an interesting morning… 

• Trump opens delicate trade negotiations with Europe by threatening US$11 billion of new tariffs on everything from cheese to helicopters. Nice – we're now familiar with El Donald's approach.. The man is simply an oik.

• Goldman Sachs earns a special award for pointing out how $420 billion of stock buybacks have been driving the market for the last decade. They might add that funding these buybacks by overleveraging in the bond markets isn't that positive either.

• Oil on something of a roll on the back of the Libya crisis and Trump roiling the Iranians.

• Aramco bond deal attracts $85 billion in orders… skewed towards the long end.. (Trying to get my head around it..)

• Brexit still in the balance. Theresa May holds the UK parliamentary record for upsetting the largest number of parliamentarians since Charles I (and that ended well, didn't it?). While most analysts expect the UK to be rewarded for agreeing absolutely nothing by granting us a deadline extension – which, of course is what Yoorp really wants so we eventually give up and vote the right way to remain – but there is a small risk a short-statured Frenchman will pull the plug. History has a tendency to repeat itself...again, and again…As always the devil will be in the detail…

But, the really shocking news this morning is I'm willing to admit I might have been wrong about something. I've repeatedly highlighted illiquidity as the biggest risk facing markets. I've written many times on how regulation has killed dealer liquidity, the death of market making, the susceptibility of a one-way market to seizing up, the risks inherent in fixed income exchange-traded fund (ETF) unwinds, and how the whole market is basically agency-dealer with intermediaries simply trying to match trades.

Consequently, skill and talent have vanished from the investment game – try finding a 25-year-old bond salesperson who understands the complexity of markets. They will bid you low, and mutter about how low interest rates mean everyone is chasing incremental yield, but your corporate bond portfolio spread does not correctly price the risk of liquidity trending towards zero. Ask for an offer, and it's a completely different story…

However, maybe I've been wrong? Maybe liquidity is not the problem? Maybe it's a misunderstanding of volatility? A fascinating comment on M&G's Bond Vigilantes Website examines the numbers: everyone is aware dealer inventory has fallen from $200 million towards $20 million today – a 90 percent decline, and assumed that's a clear signal of the end of liquidity and a sound reason for higher corporate bond risk premia.

But, the article goes on to explain how banks are making their capital committed to dealer inventory work much harder: Over the last 13 years, turnover in the IG corporate bond markets has more than doubled, while dealer inventories are being turned over 16x faster than in 2007 (a number arrived at by dividing trading volumes by dealer inventory). The gist of the numbers suggests these factors should more than compensate for the perceived drop in dealer inventories.

The M&G article is in direct contrast to recent notes from investment banks highlighting the risks of illiquidity in corporate bonds. UBS said liquidity into sell-offs and rallies is made worse by herd mentality. Bid-offer spreads on high-yield bonds widened dramatically as the market tumbled ahead of year-end last year. Deutsche Bank went further, arguing increasing defaults, regulation, illiquidity and concentration in fund structures will trigger a corporate bond meltdown.

Speaking to clients some very interesting perspectives on the liquidity debate came up.

i)                    Many portfolio managers suspect CROs (Chief Risk Officers) and compliance over-obsess about liquidity because liquidity rules are now written into investment guidelines and regulations.

ii)                   In "doom and gloom markets" the background rules create a behavioural bias to over-emphasize liquidity risks – because investors are repeatedly told it's the major risk.

iii)                 Recent bear market comments from banks have played up and fuelled liquidity risk fears in the minds of investors.

iv)                 The reality is a bid is a bid is still a bid on any decent fixed income asset. Even in poor markets there are likely to be distressed buyers even for complex assets. There is also a price for distressed assets. The key is price discovery where that price will be volatile. The trick is spotting such opportunities to buy cheap! 

v)                   There is nothing to be scared about in terms of volatility – it's critical allowing smart investors not to time the market (which is a surefire way to lose money), but to spot the right opportunities to buy and sell. 

vi)                 Certain "complex" areas of the market – such as bank capital or emerging markets, can be subject to periodic lockdown as idiosyncratic risks such as a raised bail-in threat, a capital event or political event risk. Deal with it. 

vii)               The steeper yield tourists climb up the risk mountain, for instance from high-grade into high-yield, the thinner liquidity (as measured by bid-offers) is likely to become.

viii)              The trick is to be methodical, strategic and clear – manic investors seized by perma-disaster/bear scenarios tend to be holders who lose money.

ix)                 The increase in market turnover on the M&G charts is pretty much due to increased new issue trading.

It's also a matter of tactics; my colleagues at Rubric – Shard's credit fund – point out the evidence on bid-offer vs size: LQA on Bberg shows the larger the block size, the bigger the market concession. In other words, small and diverse rather than big and discrete might work better where prices look illiquid.

What's the solution and how can I help? I think a fundamental acknowledgement that liquidity is more of a concept, an excuse, and a regulatory/compliance crutch, than a market reality, might help. There are times when finding a bid or offer is difficult in the bond market – but that's as much a function of its being a market comprising many, many discrete small instruments held by a multitude of players, and the small number of intermediaries who actually understand the complexity of what they are asked to trade. After 35 years in fixed income, I may be an old dog, but I know what works..

It's become very easy for investment chiefs to glance at liquidity and order their teams to avoid illiquid instruments, using "illiquidity" as an excuse rather than a function of the investment decision. That call misses the moment when "illiquidity" and volatility create opportunities. 

Volatility is a good thing. One trick is finding the right intermediary who understands their market – in my case, my speciality is dealing with the "special situation" investment teams who invest in complex asset-backed, equity/mezzanine/senior debt structures in the "alternatives" space. It's maybe time I get back to using my knowledge of areas such as the aviation space – if anyone is looking for ideas or to trade in aviation-linked bonds and we're not already talking, maybe it's time we did!

Finally, a complaint. She-who-is-now-Mrs-Blain and I have been using an app called Calm. It might sound silly, but listening to a bedtime story is a great way to fall deeply asleep. The anodyne gently read tale of the Earth viewed from outer space, a train trip to Cornwall, or a discussion of giant redwoods in California have me asleep in moments. 

Until last night. I made the mistake of listening to Henry Blofeld's short story explaining cricket. It was so interesting I couldn't sleep for hours. Calm will be receiving a VAL (Very Angry Letter) and I'll be buying Blofeld's book to read on the flight to Australia later this week. 

Out of time and back to the day job...

Bill Blain

Shard Capital





This site, like many others, uses small files called cookies to customize your experience. Cookies appear to be blocked on this browser. Please consider allowing cookies so that you can enjoy more content across fundservices.net.

How do I enable cookies in my browser?

Internet Explorer
1. Click the Tools button (or press ALT and T on the keyboard), and then click Internet Options.
2. Click the Privacy tab
3. Move the slider away from 'Block all cookies' to a setting you're comfortable with.

Firefox
1. At the top of the Firefox window, click on the Tools menu and select Options...
2. Select the Privacy panel.
3. Set Firefox will: to Use custom settings for history.
4. Make sure Accept cookies from sites is selected.

Safari Browser
1. Click Safari icon in Menu Bar
2. Click Preferences (gear icon)
3. Click Security icon
4. Accept cookies: select Radio button "only from sites I visit"

Chrome
1. Click the menu icon to the right of the address bar (looks like 3 lines)
2. Click Settings
3. Click the "Show advanced settings" tab at the bottom
4. Click the "Content settings..." button in the Privacy section
5. At the top under Cookies make sure it is set to "Allow local data to be set (recommended)"

Opera
1. Click the red O button in the upper left hand corner
2. Select Settings -> Preferences
3. Select the Advanced Tab
4. Select Cookies in the list on the left side
5. Set it to "Accept cookies" or "Accept cookies only from the sites I visit"
6. Click OK

Blain's Morning Porridge 

"Ashley Giles trundles in to bowl rather like a wheelie bin... " 

What an interesting morning… 

• Trump opens delicate trade negotiations with Europe by threatening US$11 billion of new tariffs on everything from cheese to helicopters. Nice – we're now familiar with El Donald's approach.. The man is simply an oik.

• Goldman Sachs earns a special award for pointing out how $420 billion of stock buybacks have been driving the market for the last decade. They might add that funding these buybacks by overleveraging in the bond markets isn't that positive either.

• Oil on something of a roll on the back of the Libya crisis and Trump roiling the Iranians.

• Aramco bond deal attracts $85 billion in orders… skewed towards the long end.. (Trying to get my head around it..)

• Brexit still in the balance. Theresa May holds the UK parliamentary record for upsetting the largest number of parliamentarians since Charles I (and that ended well, didn't it?). While most analysts expect the UK to be rewarded for agreeing absolutely nothing by granting us a deadline extension – which, of course is what Yoorp really wants so we eventually give up and vote the right way to remain – but there is a small risk a short-statured Frenchman will pull the plug. History has a tendency to repeat itself...again, and again…As always the devil will be in the detail…

But, the really shocking news this morning is I'm willing to admit I might have been wrong about something. I've repeatedly highlighted illiquidity as the biggest risk facing markets. I've written many times on how regulation has killed dealer liquidity, the death of market making, the susceptibility of a one-way market to seizing up, the risks inherent in fixed income exchange-traded fund (ETF) unwinds, and how the whole market is basically agency-dealer with intermediaries simply trying to match trades.

Consequently, skill and talent have vanished from the investment game – try finding a 25-year-old bond salesperson who understands the complexity of markets. They will bid you low, and mutter about how low interest rates mean everyone is chasing incremental yield, but your corporate bond portfolio spread does not correctly price the risk of liquidity trending towards zero. Ask for an offer, and it's a completely different story…

However, maybe I've been wrong? Maybe liquidity is not the problem? Maybe it's a misunderstanding of volatility? A fascinating comment on M&G's Bond Vigilantes Website examines the numbers: everyone is aware dealer inventory has fallen from $200 million towards $20 million today – a 90 percent decline, and assumed that's a clear signal of the end of liquidity and a sound reason for higher corporate bond risk premia.

But, the article goes on to explain how banks are making their capital committed to dealer inventory work much harder: Over the last 13 years, turnover in the IG corporate bond markets has more than doubled, while dealer inventories are being turned over 16x faster than in 2007 (a number arrived at by dividing trading volumes by dealer inventory). The gist of the numbers suggests these factors should more than compensate for the perceived drop in dealer inventories.

The M&G article is in direct contrast to recent notes from investment banks highlighting the risks of illiquidity in corporate bonds. UBS said liquidity into sell-offs and rallies is made worse by herd mentality. Bid-offer spreads on high-yield bonds widened dramatically as the market tumbled ahead of year-end last year. Deutsche Bank went further, arguing increasing defaults, regulation, illiquidity and concentration in fund structures will trigger a corporate bond meltdown.

Speaking to clients some very interesting perspectives on the liquidity debate came up.

i)                    Many portfolio managers suspect CROs (Chief Risk Officers) and compliance over-obsess about liquidity because liquidity rules are now written into investment guidelines and regulations.

ii)                   In "doom and gloom markets" the background rules create a behavioural bias to over-emphasize liquidity risks – because investors are repeatedly told it's the major risk.

iii)                 Recent bear market comments from banks have played up and fuelled liquidity risk fears in the minds of investors.

iv)                 The reality is a bid is a bid is still a bid on any decent fixed income asset. Even in poor markets there are likely to be distressed buyers even for complex assets. There is also a price for distressed assets. The key is price discovery where that price will be volatile. The trick is spotting such opportunities to buy cheap! 

v)                   There is nothing to be scared about in terms of volatility – it's critical allowing smart investors not to time the market (which is a surefire way to lose money), but to spot the right opportunities to buy and sell. 

vi)                 Certain "complex" areas of the market – such as bank capital or emerging markets, can be subject to periodic lockdown as idiosyncratic risks such as a raised bail-in threat, a capital event or political event risk. Deal with it. 

vii)               The steeper yield tourists climb up the risk mountain, for instance from high-grade into high-yield, the thinner liquidity (as measured by bid-offers) is likely to become.

viii)              The trick is to be methodical, strategic and clear – manic investors seized by perma-disaster/bear scenarios tend to be holders who lose money.

ix)                 The increase in market turnover on the M&G charts is pretty much due to increased new issue trading.

It's also a matter of tactics; my colleagues at Rubric – Shard's credit fund – point out the evidence on bid-offer vs size: LQA on Bberg shows the larger the block size, the bigger the market concession. In other words, small and diverse rather than big and discrete might work better where prices look illiquid.

What's the solution and how can I help? I think a fundamental acknowledgement that liquidity is more of a concept, an excuse, and a regulatory/compliance crutch, than a market reality, might help. There are times when finding a bid or offer is difficult in the bond market – but that's as much a function of its being a market comprising many, many discrete small instruments held by a multitude of players, and the small number of intermediaries who actually understand the complexity of what they are asked to trade. After 35 years in fixed income, I may be an old dog, but I know what works..

It's become very easy for investment chiefs to glance at liquidity and order their teams to avoid illiquid instruments, using "illiquidity" as an excuse rather than a function of the investment decision. That call misses the moment when "illiquidity" and volatility create opportunities. 

Volatility is a good thing. One trick is finding the right intermediary who understands their market – in my case, my speciality is dealing with the "special situation" investment teams who invest in complex asset-backed, equity/mezzanine/senior debt structures in the "alternatives" space. It's maybe time I get back to using my knowledge of areas such as the aviation space – if anyone is looking for ideas or to trade in aviation-linked bonds and we're not already talking, maybe it's time we did!

Finally, a complaint. She-who-is-now-Mrs-Blain and I have been using an app called Calm. It might sound silly, but listening to a bedtime story is a great way to fall deeply asleep. The anodyne gently read tale of the Earth viewed from outer space, a train trip to Cornwall, or a discussion of giant redwoods in California have me asleep in moments. 

Until last night. I made the mistake of listening to Henry Blofeld's short story explaining cricket. It was so interesting I couldn't sleep for hours. Calm will be receiving a VAL (Very Angry Letter) and I'll be buying Blofeld's book to read on the flight to Australia later this week. 

Out of time and back to the day job...

Bill Blain

Shard Capital



Free subscription - selected news and optional newsletter
Premium subscription
  • All latest news
  • Latest special reports
  • Your choice of newsletter timing and topics
Full-access magazine subscription
  • 7-year archive of news
  • All past special reports
  • Newsletter with your choice of timing and topics
  • Access to more content across the site

More on:  Market commentary