Setting New Standards
The Liquidity Challenge II
may 2013
BlackRock
Investment
Institute
Richard Prager
Head of BlackRock
Trading and Liquidity
Strategies
Setting New Standards
A bull market can disguise many sins. Take the corporate bond market. On the
surface, everything appears hunky dory. Issuance is at record levels, investors are
desperate for yield in the zero-rate world and price performance has been great.
Things look shakier up close. It is not easy to buy and sell bonds in secondary
markets. Liquidity is patchy, and many bonds have turned into museum pieces:
nice to look at, but tough to take home. This is likely a structural shift.
Kashif Riaz
Member of
BlackRock’s
Global Capital
Markets team
We analyze the state of play and debate a potential liquidity driver: bond
standardization. We focus on the world’s largest corporate bond market: the
$5.5 trillion investment grade (IG ) US market. Our main observations:
Investors pay a premium to hold high-volume IG bonds rather than illiquid
alternatives. Individual bond trading volumes tend to plunge as new issues
age and overall bid-offer spreads remain above pre-crisis levels.
Supurna Vedbrat
Co-Head of
BlackRock Market
Structure
and Electronic
Trading team
 Sporadic and lumpy issuance has created a highly fragmented market, and new
issues dominate trading. Any effort to improve liquidity must address issuance.
Standardization would involve steps such as issuing similar amounts and
maturities at set times, and re-opening benchmark issues. This would cut down
the jungle of bonds, create a liquid curve for top individual issuers and enable
lower-cost hedging with centrally cleared derivatives.
The obstacle: Many issuers and investors like the status quo. Issuers will
Ewen Cameron Watt
Chief Investment
Strategist, BlackRock
Investment Institute
have to evaluate flexibility against potentially lower costs and a simpler
capital structure. Investors need to weigh new issue gains and strategies
exploiting liquidity differences versus the ability to trade in size.
Some standardization looks unavoidable in the long run. Drivers are the advent
of bond exchange traded funds (see Behind the Bond Boom of January 2013),
increased electronic trading (which feeds off standardization, and vice-versa) and
(perhaps) new issuance models such as auctions.
WHEN THE DEALER STOPS DEALING
IG
MA
R
US Primary Dealers’ Corporate Bond Inventory, 2001–2013
% OF TOTAL
$200
$5.6 bn
$11.8 bn
0.25
BILLIONS
150
T
KE
$10.5 bn
100
50
0
2003
2005
2007
2009
2011
2013
Commercial Paper ■
Investment Grade ■
High Yield ■
Source: New York Federal Reserve, May 2013.
Notes: The left chart contains some non-corporate securities such as collateralized mortgage obligations issued by entities other than US federal agencies or government
sponsored enterprises. In April 2013, the position reporting structure changed to give the more detailed breakdown of corporate positions shown in the pie chart.
The opinions expressed are as of May 2013 and may change as subsequent conditions vary.
[2]
SETT I NG NEW STANDA R DS
IS THIS A BULL MARKET?
US IG Bond Volume as % of Outstanding Debt, 2005–2013
SHARE OF OUTSTANDING DEBT
120%
Primary dealers’ inventories of US corporate bonds have
plummeted 76% from a high of $235 billion in 2007. See
the left chart on the previous page. The cupboards are
bare. Dealers currently hold just 0.25% of the total IG
debt outstanding, as the right pie chart shows.
Result: Dealers increasingly have to match buyers and
sellers in real time—or tell investors they are on their own.
Investors are hunting for alternative sources of liquidity and
exploring new ways to trade. Think client-to-client trading
and/or exchange-like venues with a central order book.
110
100
90
80
70
2005
2007
2009
2011
2013
Source: MarketAxess, March 2013.
Note: Represents 12-month rolling value of trade as a share of outstanding debt.
Corporate bond investors often complain it is tough
to buy in size. They also worry what will happen when
interest rates spike and the whole world pushes the
sell button. They have a point: Trading volumes have
fallen off a cliff when measured as a percentage
of the market’s total outstanding debt. See the
chart above.
The reasons: Yield-hungry investors who used to dismiss
corporate bonds as too risky are stampeding into the
market. But traditional liquidity providers such as dealers
and proprietary trading desks are retreating. Drivers
include risk aversion and stricter capital rules, as detailed
in Got Liquidity? in September 2012.
The rise of these new trading venues could push down
transaction costs (as it has in other markets), increase
liquidity and set the stage for more standardization. It
could also start chipping away at the main reason for poor
liquidity: too many different but similar bonds.
Trading is fragmented across thousands of bonds of varying
maturities. Companies tend to issue bonds whenever
financing needs arise or opportunities present themselves.
By staggering issuance schedules and diversifying across
maturities, companies can minimize risks of refinancing and
higher rates when credit markets are expensive (or closed,
as many discovered during the financial crisis).
This flexibility may be convenient for issuers but makes life
complicated for bond investors. Investors who want to buy
GE or J.P. Morgan common shares have one easy choice.
Bond investors must sift through thousands of issues
even for the top 10 corporate issuers, as the table below
shows. Most bonds are not liquid enough to be included in
benchmarks such as the Barclays US Corporate Index. (The
index eligible bonds, however, make up an average of 37%
of the total in dollar terms. See the table’s second column.)
TOO MANY TREES IN THE BOND FOREST
Bonds and Shares Outstanding of Top US IG Bond Issuers
Bonds in Barclays
US Corporate Index
Share of Dollar
Amount Outstanding
GE
44
J.P. Morgan
32
issuer
TOTAL Bonds
Outstanding
Common Equity
Securities
Preferred Equity
Securities
31.2%
1,014
1
4
34.1%
1,645
1
13
Goldman Sachs
25
38.4%
1,242
1
8
Citigroup
39
35.8%
1,965
1
12
Morgan Stanley
29
40.1%
1,316
1
12
Bank of America
30
28.2%
1,544
1
39
AT&T
29
62.6%
74
1
0
Wal-Mart
26
71.6%
50
1
0
Verizon
26
60.8%
71
1
0
Wells Fargo
15
26.2%
274
1
8
Sources: Barclays and Bloomberg, May 2013. Note: Table shows issuers with the largest notional amount outstanding in the Barclays US Corporate Index.
B LACK R OCK I NVESTMENT I NST I TUTE
[3]
THE ISSUE IS ISSUANCE
US IG Bond and Equity Issuance, 2000–2012
$5
SHARE OF AMOUNT OUTSTANDING
25%
TRILLIONS
4
3
2
1
0
2000
2002
2004
2006
Amount Outstanding ■
2008
2010
20
IG Bonds
15
10
5
Equities
0
2012
2000
2002
2004
2006
2008
2010
2012
Gross New Issue Supply ■
Sources: J.P. Morgan, Dealogic and World Bank. Note: Equity new issuance includes follow-on offerings. The percentage share is based on the total US equity market capitalization.
New issuance is the lifeblood of the IG market. Total issuance
has surged in recent years, as the left chart above shows.
Companies have taken advantage of record-low yields to
refinance their debt cheaply, and many blue chips are
borrowing money to buy back their own shares (think Apple).
IG issuance tends to be sporadic—driven by borrowers’
seasonal demand and investor appetite. See the right chart
below. It also differs by region. For example, 10-year bonds
dominate the US market with a 37% share in 2012, according
to J.P. Morgan, compared with 3-years in the Eurozone (40%).
Annual gross supply has averaged 21% of total IG debt
outstanding over the past decade, compared with just
1% for US equities, as the right chart above shows. In
other words, the makeup of the corporate bond market
is transformed every year. This means any effort to
improve liquidity must start with issuance practices.
US Treasury issuance is much more standardized: Similar
amounts of the same maturity dates are auctioned each
month (at roughly the same time). Suppose top IG issuers
were to align maturity dates with centrally cleared swaps,
and standardize issuance amounts and timing. This would
lay the foundation for a liquid IG curve.
IT’S AN ISSUER’S MARKET
US Government and IG Gross Issuance, 2012–2013
CORPORATE
GOVERNMENT
$160
TIPS
30 Year
10 Year
80
7 Year
75
BILLIONS
120
BILLIONS
$100
50
5 Year
25
40
3 Year
2 Year
0
May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
0
May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
Sources: US Treasury and J.P. Morgan, April 2013. Note: Government issuance is based on the amount offered at auctions.
[4]
SETT I NG NEW STANDA R DS
‘On the run’ bonds, which are generally the issuer’s most
recently issued securities, enjoy deeper markets and
narrower credit spreads, as detailed on the next page.
‘Off the run’ securities, which are more seasoned and
tend to trade in smaller sizes, are more costly to transact
and generally trade at wider spreads.
THE THRILL OF SOMETHING NEW
ANNUALIZED SHARE OF OUTSTANDING DEBT
IG Trading Volumes by Age of Issue
300%
This makes it tough for large investors to transact in size
or to exit a position in a hurry. “If you buy it, you better love
it,” could be the new mantra for IG investors.
200
100
Most Likely to Standardize
0
0
100
200
300
400
500
600
700
DAYS SINCE ISSUANCE
Source: MarketAxess, May 2013.
Note: Trades since Jan. 1, 2012, on bonds issued after Jan. 1, 2010.
Everybody loves new issues. Newly printed bonds change
hands frequently at first, but activity drops off soon.
See the chart above. Within just four weeks of issuance,
trading volume has plummeted by around 50%. Within two
months, annualized volume has slowed to just one time
the bond’s total dollar amount.
After that, most bonds are carted off to the museum.
There they are on display—but attract few visitors.
The United States, home to the world’s largest corporate
bond market, is likely to lead the way in standardization.
In most of Europe and Japan, bank lending still dominates
corporate finance, as the left chart below shows. This is
starting to change. Bank credit to nonfinancial firms has
been declining since 2008 because banks have become
more risk-averse and are deleveraging. See the right
chart below.
Result: Companies will increasingly tap capital markets.
This has already happened in emerging markets, as
detailed in What’s Developing in April 2013.
Just as many developing countries leapfrogged fixed-line
infrastructure and jumped straight to wireless, fledgeling
corporate bond markets now have the opportunity to
develop a more liquid market structure for the future.
ROOM FOR DEVELOPMENT
BANK LENDING
80%
50%
60
40
SHARE OF GDP
SHARE OF GDP
Bank Lending vs. Corporate Bond Markets, 2011
40
30
20
20
0
10
2000
US Germany France
Italy
Japan
UK
Ireland Spain
Corporate Bond Market ■
Bank Credit ■
2002
2004
2006
2008
2010
EU
UK
US
Source: Bruegel Working Paper, March 2013. Note: Bank lending to non-financial corporations only.
B LACK R OCK I NVESTMENT I NST I TUTE
[5]
CONCEDING LESS
New IG Bond Issue Concessions, 2007–2013
100
75
BASIS POINTS
Investors currently are willing to pay a premium for liquid IG
bonds. See the chart below. The liquidity premium, which
increased as dealer inventories fell after the crisis, would
likely dissipate in a more standardized market. This would
be good news for investors wanting to allocate to a wide
spectrum of bonds or move quickly in and out of positions.
Investors who exploit price differences between liquid and
tough-to-trade bonds, by contrast, would need to develop
new market-beating strategies (after cashing in on the initial
convergence trade).
50
25
PREMIUM LIQUIDITY
Spread Between Illiquid and Liquid IG Bonds, 2005–2013
0
2009
30
Source: J.P. Morgan. Note: The average new issue concession is the difference
between the spread at which the new issue printed and the spread at which
corresponding bonds trade in the secondary market. The average is a 10-day
running average weighted by the size of the newly issued bond.
10
This is great for issuers—and gives them less incentive
to give up flexibility in issuance. See the chart above. This
seller’s market is unlikely to last if rates were to back up or if
credit were to deteriorate.
0
-10
2007
2009
2011
2013
Source: J.P. Morgan, April 2013. Notes: Liquid bonds are those with a daily turnover in
excess of $3 million. Illiquid bonds are those with a turnover of less than $1 million a day.
Bid-offer spreads on US IG corporates have remained
stubbornly high at around 5 basis points, roughly the
same level as a decade ago. Compare this with bid-ask
quotes as low as 1 basis point in agency mortgage bonds.
Trading costs eat up around 3.5% of the overall IG spread
over Treasuries, compared with 3% in 2003. See the chart
on the right. In a zero-rate world, every basis point matters.
IG corporates currently yield about 2.7% versus 4.1% a
decade ago. This means bid-offer spreads equal 1.2% of
total yield, up from 0.8% in 2003.
Remember this is the best of times. Liquidity in the corporate
bond market can turn on a dime. When everybody rushed for
the exits in late 2008, bid-offer spreads ballooned to more
than 8% of the total spread—if there was a market at all.
The hunt for yield has also pushed down new issue
concessions (the yield “sweetener” issuers add to get
investors to buy their new paper) to almost zero.
Bond investors relying on “easy alpha,” buying as much as
possible of a new issue for an immediate price gain in the
secondary market, are still flying high. The decline in new
issue concessions has been offset by a widening premium
for bonds that trade near par (newly issued bonds) and those
at a premium (older issues). This reflects relative liquidity.
See the top chart on the next page. If standardization
were to take hold, these investors are in trouble: There
likely would be few free alpha lunches in the future.
what’s on offer
IG Bid-Offers as % of Overall Spread, 2002–2013
8%
SHARE OF SPREAD
BASIS POINTS
20
2005
6
4
2
0
2001
2003
2005
Source: MarketAxess, May 2013.
[6]
2013
2011
SETT I NG NEW STANDA R DS
2007
2009
2011
2013
A concurrent step would be to standardize maturity dates.
This would align corporate bonds with centrally cleared
interest rate swaps and credit derivatives, making it less
costly to hedge. The downside for issuers: It would concentrate
refinancing risk around certain dates such as quarter ends.
To mitigate this, the bonds could include an option for issuers
to call the debt in the three months prior to maturity.
par FOR THE COURSE
Spread Between Par and Premium IG Bonds, 2005–2013
30
10
0
-10
-20
-30
2005
FEE FEST
Top US Investment Grade Bond Issuers in 2012
issuer
Amount
Raised
($ mlns)
fees
($ mlns)
Share of
Amount
Raised
GE
$29,924
$154.3
0.52%
J.P. Morgan
$17,825
$89.8
0.5%
Abbott
$14,657
$50.5
0.34%
Toyota Motor
$13,751
$29.1
0.21%
Wells Fargo
$12,692
$70.1
0.55%
Goldman Sachs
$12,497
$47.6
0.38%
United Tech.
$9,753
$52.3
0.54%
Citigroup
$9,302
$33.3
0.36%
AT&T
$8,992
$30.8
0.34%
Deere
$8,331
$31.5
0.38%
Total
$137,724
$589.3
0.43%
Why would issuers want to trade flexibility in issuance for
potential maturity walls? The immediate answer is simple:
They do not want this trade. Longer term, this may be
different. Fewer bonds mean lower regulatory costs,
and standardization could lower financing costs.
2009
2011
2013
New issue concessions are negligible at this point, but this
issuer nirvana may not last. A liquid curve could attract a
steady source of demand: exchange traded products. A key
cost for issuers is the issuance process itself. Underwriting
fees average 43 basis points for top IG issuers. See the
table on the left. A potential shift toward (cheaper) auctions
of new issues would likely go hand in hand with
standardization. Previous attempts at auctions have failed,
but improved technology, insatiable investor demand and
dealer retrenchment could create a new catalyst.
1
Q U E S TION S TO C ON S IDER
Our view: The market has not demanded it because of
the one-way demand for credit in the past three years.
Re-openings are generally not priced at par ($100). Issuers
prefer par bonds due to their more streamlined accounting
treatment. Investors also like them because premium bonds
carry a higher credit risk: Maximum recovery is capped at
$100 in case of default. A change in the rate cycle could
change this dynamic because many bond prices could
drift toward par or below.
2007
Source: J.P. Morgan. Note: The spread is calculated between similar par bonds and
premium bonds that have a price differential of more than $15. The spread widened to
-186 basis points in 2008 due to market distortions caused by the global financial crisis.
Sources: Thomson Reuters and Freeman Consulting.
Standardization appears a natural step, given that related
markets such as CDS and agency mortgage bonds have
blazed a trail. Why has it not happened yet?
Dislocation due to
Financial Crisis
20
BASIS POINTS
More frequently re-opening issues could boost liquidity. An
original 2023 bond could be reopened in 2018 as the 5-year
benchmark and in 2020 as the 3-year benchmark. Over
time, large borrowers would develop a single, liquid security
at each annual curve point. Tenders and exchanges could
accelerate the process.
INVESTORS: Are you ready to give up
new issue gains and liquidity strategies for lower
transaction costs, access to more bonds and the
ability to buy (and sell) in size?
2
ISSUERS: Are you assessing the benefits of
standardization (potentially lower issuance costs and
lower legal fees) against the cost (a loss of flexibility
and the risk of maturity walls)?
3
Bankers: Are you preparing for a more
standardized future by exploring ways to structure
debt offerings to improve liquidity or do you think
the status quo is sustainable?
4
Trading Venues: Are you developing new
ways to trade beyond the standard client-to-dealer
RFQ (request for quote) protocol, such as client-toclient order matching and a central order book?
5
Regulators: Given your concerns about
market liquidity and transparency, should you think
about standardization and how to promote it?
B LACK R OCK I NVESTMENT I NST I TUTE
[7]
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