The regulatory response to the 2008 financial crisis continues to shape the markets in unexpected ways.
We're now seeing one unintended effect in the corporate-credit market, which has become significantly less liquid over the past year as primary dealers have reduced credit inventory in response to new banking regulations.
At the same time, investors' thirst for higher-yield credit has driven explosive growth in fixed-income exchange-traded funds, whose sheer size and tendency to trade as a block now distort an ever-shrinking market.
The financial crisis prompted a wave of cost cutting and balance sheet derisking at banks, and new banking regulations aimed at preventing future crises have altered market dynamics further.
In response to market and regulatory changes, investment banks have reduced inventories of corporate-credit securities by about 50% over the past year. At the end of March, banks held roughly $49 billion in corporate securities with more than one year to maturity, compared with $88 billion a year earlier, according to the
Federal Reserve Bank of New York.
Why do inventories matter? Because the corporate-credit market is an over-the-counter market that relies on dealers' acting as market makers. Some of the Wall Street investment banks that formerly acted as primary dealers, such as Lehman Brothers Holdings Inc. and The Bear Stearns Cos. Inc., no longer exist. Others have reduced inventory and are participating less actively in the market.
At the same time, U.S. corporate-debt issuance has grown as companies seek to take advantage of low interest rates to issue or refinance debt. Between March 2011 and March 2012, as dealer inventories fell by half, the total amount of outstanding U.S. corporate credit rose to approximately $3.7 trillion, according to
Barclays PLC. The effects of shrinking dealer inventory are even more pronounced as the total pool of outstanding securities grows.
Also, with fewer dealers buying and selling bonds, investors often find a liquidity gap between bid and offer prices.
THE RISE OF BOND ETFS
Meanwhile, investors seeking yield have been attracted by the relative value of corporate credit. One of the most obvious ways for them to enter this market is through fixed-income ETFs.
However, while equity ETFs generally own the stocks in a benchmark, a bond index may contain thousands of individual securities. It is not practical for fixed-income ETFs to own them all. Instead, they attempt to track a benchmark's characteristics by buying credit issued by the largest, most liquid and most recent issuers represented in the benchmark. The largest issuers of debt, however, may not be the best issuers, in terms of creditworthiness.
ETFs have a short window in which to invest the funds they receive from investors, and generally will invest regardless of price. These indiscriminate buyers can become indiscriminate sellers. When ETFs buy or sell the same security at the same time, their activity exaggerates its price movement.
MEETING THE CHALLENGE
We continue to believe that corporate credit offers some of the best risk-adjusted-return opportunities available. In our opinion, there are several key strategies for long-term success:
Select credit securities based on research. Identify the securities of companies that are fundamentally improving and engaging in capital structure transformation, versus those that are sought merely for beta.
Identify momentum securities. ETF momentum traders can cause prices to “gap” lower or higher, making it difficult for other investors to execute trades at a desired time or price.
Take advantage of discounts and premiums. Market dislocations can cause fundamentally attractive credits to be undervalued due to supply-demand imbalances, while at other times, they may be overvalued because of high demand from ETFs.
Use credit default swaps with caution. The credit market and the credit default swaps market are interconnected, and price gaps that occur in the credit market as a result of illiquidity likely would be reflected in credit default swaps, as well. Derivatives such as these may introduce new risks that may not be appropriate for investors.
Investors naturally will seek higher yields, but it's important to understand the new risks in today's credit market.
Gibson Smith is co-chief investment officer and co-portfolio manager at Janus Capital Management LLC.
