Secondary bond markets: ‘Bye and hold
Secondary market illiquidity is taking its toll in Europe.
The evaporation of secondary bond market liquidity in Europe is one of the most worrying by-products of the region’s bank-funding crisis. Primary volumes in the first quarter of this year have been off the charts while secondary volumes remain stubbornly subdued. Indeed, bonds are often cheaper in the primary market than in the secondary market.
More worrying still is that there seems little sign that the situation is likely to improve.
Michael Ridley, managing director at JPMorgan, illustrated the parlous state of the secondary market at the International Capital Market Association AGM in May. Explaining that the US bank traded 5,000 names last year, Ridley noted that of the top 1,000 bonds, just eight traded more than three times a day. Twenty-six traded twice a day, 134 once a day and 832 traded just three times a week. Ridley added that 145,000 bonds on the bank’s books did not trade at all in 2011.
Lack of secondary liquidity has obvious implications for price discovery and it also makes markets far more volatile. There is no escaping the fact that banks are essential to provide the necessary depth in the European capital market.
However, new regulation has made it far less attractive for them to do so. There are far more profitable ways for dealers to use their now scarce and expensive capital than by trading vanilla bonds.
Credit investors have welcomed the market’s move towards pure market making and away from the distortive very large trading books that the banks used to run – which were a leveraged bet on the assets and drove credit spreads to artificial lows. But they also complain that there is a continued reluctance by dealers to commit enough capital to provide liquidity to their institutional clients. Dealers argue that there is an equal reluctance by investors to pay the true price of this provision.
This dearth of secondary market liquidity is prompting a profound and lasting change in the European investor base. Investors in Europe have had to adjust their mentality: they have to be prepared to hold securities. Smaller buyers that do not have the capability to do this cannot risk buying when secondary liquidity is this thin.
The investor base is therefore morphing into a buy-and-hold market that is dominated by those institutions that are able to invest for the long term. It is becoming concentrated into larger and more powerful institutions, of which BlackRock is only the most obvious example. These buyers need to trade larger blocks of securities in meaningful volumes.
Four European banks, Deutsche Bank, Dexia, ING and Rabobank, now have their asset management businesses up for sale and the numbers will likely grow.