Playing Hot Potato in the Bond Market

Many of you probably know of the scene in the movie “Jurassic Park” in which a scientist, played by actor Jeff Goldblum, mentions the concept of chaos theory to his fellow scientists to warn of dangers that may lurk in the park as they begin to trek through it.

While investors need not worry about getting eaten up by dinosaurs, they do have to concern themselves with the possibility that their money can get eaten up by extreme market volatility now and then.

The reason relates to market liquidity. It has deteriorated markedly since the 2008 financial crisis, owing to post-crisis regulations and changed business models that discourage financial intermediaries from holding financial securities. That has led to a broken principal-agent model whereby intermediaries are either unwilling or unable to hold securities and take risk as they once did. As a result, investors who attempt to sell bonds to those intermediaries often find themselves inadvertently entering a game of hot potato that goes something like this:

Intermediary A: “I don’t want it, you take it.”

Intermediary B: “Me either; you take it.”

Intermediary C: “I’ll take it, but here’s my price and you can take it or leave it.”

Figures 1 and 2 capture that conversation and today’s impaired principal-agent model. For added context, keep in mind that the U.S. bond market has grown substantially since 2008, with the corporate bond market roughly doubling in size and the Treasury market about three times larger. Think about it as a lot more fluid having to pass through an ever-constricted pipe.

Figure 1 illustrates the sharp decrease in dealer holdings of corporate bonds that occurred in the aftermath of the 2008 global financial crisis. Recent data from the New York Federal Reserve indicate that trend persists, with dealer holdings under $10 billion at the end of August 2022.

Figure 1.

As of December 31, 2019

Figure 2.

Source: Federal Reserve, U.S. Treasury Department, as of July 2022.

Chaotic endings to credit cycles may now be the norm

Given the above, it may behoove investors to expect future credit cycles to end chaotically, as they did in 2008 and 2020. The financial system on occasion apparently can no longer handle the vast and ever-growing amount of debt securities that must pass through it. Credit spreads therefore have greater potential than ever to widen more than is warranted by default risk alone.

As an example, consider the historical default risk on Baa-rated corporate bonds, which is the lowest-rated investment-grade bond. Data from Moody’s covering the period from 1920 to 2006 indicate that the average default rate for those bonds was 0.27%, meaning investors had a 99.73% chance of getting repaid at maturity. An investor in the top-rated Baa bond tier (Baa1) had a 99.9% of getting repaid.?[i]

Despite those impressive numbers, they were immaterial in 2008 and 2020, when the implied default rates soared on corporate bonds, owing in no small part to deterioration in market liquidity and the game of hot potato it has produced. Liquidity matters a great deal for high-quality bonds – within corporate bonds, the Baa segment is the largest, representing about half of that market, making it prone to significant selling volume. Heck, even the U.S. Treasury market can be subjected to the negative influence of liquidity conditions.

The proclivity toward chaotic price volatility – in all credit instruments – can be prompted unexpectedly by a wide variety of unpredictable influences. The pandemic was simply the most recent catalyst to awaken this dynamic.

It therefore can be said that the bond market is prone to a “butterfly effect,” which is a widely known chaos theory advanced by Edward Lorenz in a 1972 study titled, “Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set Off a Tornado in Texas?” As the title suggests, volatility can arise from a variety of sources, included from many one would not easily expect.

An investor therefore does not need a crystal ball to predict what will cause the next chaotic move in the financial markets; they simply need understand that the system is prone to significant price volatility in stressful times and stay mindful of this structural condition when constructing and managing bond portfolios.

Playing the game

There are several ideas for investors to consider when attempting to mitigate liquidity risks and improve their credit holdings’ resilience to interest-rate volatility. Some of these strategies could put an investor in a position to take advantage of the liquidity problem.

1. Choose liquid proxies to obtain credit beta. That may mean choosing a credit index over cash instruments. It can also mean investing in agency mortgage-backed securities, which tend to fare better than corporate bonds in times of stress, lagging in risk-on periods. Valuations are more compelling than they have been in some time for those securities, and it is a way to “toe” into the credit realm.
2. Reduce overall risk exposure, focusing on risk factors including credit, liquidity, and equity risk in particular.
3. Analyze the expected resiliency of cash flows for credit instruments under different economic scenarios.
4. Prefer securities whose cash flows have seniority over others from the same entity.
5. Reduce holdings in economically sensitive sectors.
6. Increase overall portfolio liquidity, including holdings in the short-term realm, which today may enable an investor to get paid a reasonable return relative to expected inflation (over the medium term) while awaiting better conditions for adding risk exposures.
7. Consider exploring interval funds, which do not provide daily liquidity. They are designed to provide investors periodic liquidity with greater access to less-liquid investments than open-end funds, with portfolio managers not having to be concerned as much about daily redemption requests.
8. Take advantage of recent shifts in relative value between public and private credit markets. As investors have reconsidered economic and credit risks this year, public markets have led the decline, and lately, you can find greater yields for similar risk within public markets vs. private markets. Investors might even consider shifting some assets from private strategies into opportunities in public markets, which also tend to be more liquid.

I expect the game of hot potato to be a constant feature of the ever-growing bond market for years to come. To my thinking, investors therefore should consider positioning their portfolios to guard against chaotic price movements as well as to take advantage of them. Attempts to predict the causes of those price movements are likely to be futile, so it is probably better to play the game of hot potato wisely.

[i]?https://www.moodys.com/sites/products/DefaultResearch/2006400000429618.pdf

Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee.?Click?here?for more about Tony.

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