Friday, October 17, 2014

What about the bond market?

As stocks rally this morning, one's attention could turn to the bond market.  The New York Times business section today has an attention getting article on the high yield bond market, and the concentrated positions of some major asset managers.  Here equities are followed closely, and presumed to be understood based on career experience and years of investing.  Bonds are understood, but individual bonds are not followed or bought.  That's not an area of expertise or experience.  Low cost mutual funds are the primary avenue of bond exposure here.

That's the reason, no doubt, that today's mentioned article was so enlightening, or maybe alarming, when read this morning.  The high yield debt positions that are dominated by one or more firms could, in a market crisis, lead to a liquidity squeeze that would destabilize the credit markets in a way that would be reminiscent of the 1998 LTCM crisis, and as one who was on the front lines then it is an understatement to say be that one was a real nail biter.

What is being talked about here?  Examples in the article include the apparent facts that:  Pimco owns close to 50% of a number of foreign bonds;  Pimco owns over 40% of the debt issued by the Bank of China and just under 40% of State Bank of India debt;  Pimco owns 37% of Ally Financial(the old GMAC) debt;  Franklin Templeton owns 25% of First Data debt and 24% of Tenet Healthcare debt; Franklin Templeton also has a "big bet" on bonds from Ireland and Ukraine.  Other firms like Fidelity Investments, Dodge and Cox, and Blackrock have "significant though smaller" positions in selected high yield debt securities.

The following sentence lifted from the article is important.  "Traders calculate that less than 1% of corporate bonds trade more than $5 million a day."  While some of the very large issues mentioned above would presumably trade more than that, the message is that any analogy between the liquidity of the stock market and the bond market may be incorrect.  In a crisis in the equity markets volumes generally increase while in a crisis in the credit markets they freeze and individual securities can become illiquid for an indefinite period of time.  If there were ever a situation where unanticipated and abruptly rising rates would lead to a rush to the exits by fund holders of major bond funds, it would lead to a period of significantly distressed selling, fund holder losses, and inevitable losses for affected bond fund manager, either through accommodations to their clients, mismatched trades in a chaotic market, or to subsequent litigation.

More importantly any liquidity driven credit events cast a shadow over the entire fixed income market, and activity tends to drastically decline or get put on hold.  That casts a pall over business activity in general, and if global the ramifications are multi-faceted.

At the moment there is enough to think about when looking at the equity market.  On the horizon, today's article was a reminder that bonds cannot be ignored.  High yield bonds in particular represent a hybrid risk, that one could view as part fixed income and part equity.  Concentrations are rarely wise, and those by certain firms require investor attention, one could hope.  The good news is that there is no such crisis in sight at the moment, so this is now just a cautionary note.

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