In the early 1990s I was a young bond trader with a Wall Street firm.
The business was not exactly like the movies, but it wasn’t too far off, either. We got to work by 7:00 a.m., set the strategy for the day — “Are we buying more or selling more?” — and then got on the phones.
The job was basically poker over the phone, trying to outbid or slightly underbid the competition, depending on the marching orders. We committed millions of dollars with no contract, no signatures, no documents… just a short statement of: “You’re done!”
At the end of the day, we’d often retire across the street to a small bar that catered to our business. We’d swap war stories of who got stuck with what bonds, or who stole inventory from whom, and then after a few rounds we’d start to slip away, back to our apartments or homes.
The next morning, we’d be at our desks by 7:00 a.m. sharp to do it all over again.
Those days are long gone for me, and now they are fading away in general. Even though there are more bonds outstanding than ever, not only are traders disappearing, but so are trades. When interest rates start to walk higher, this could pose a significant risk to individual investors.
In 2007, the top year for daily bond trading volume, there were $32 trillion of bonds outstanding. This included $4.5 trillion of U.S. Treasury bonds (net of what is owed to government trust funds), as well as $5.2 trillion of corporate bonds.
In the years since, the U.S. government has run record deficits while corporate America has taken advantage of record-low interest rates. Bonds outstanding have ballooned to $39 trillion, including $12.5 trillion of U.S. Treasurys and $7.8 trillion of corporate bonds.
With more bonds available, it stands to reason that trading volume would increase, but that hasn’t been the case.
Even though bond issuance has mushroomed, daily trading volume has contracted. From its peak of $1,036 billion in 2007, daily trading volume declined to $730 billion at the end of 2014.
Today, more of it is happening on electronic platforms matching end buyers and sellers, skipping trading desks altogether. Over the last seven years, the Primary Dealer banks have cut their bond trading volume by 75%, due to increased pressure from capital requirements placed in the aftermath of the financial crisis. That leaves a lot of empty desks.
Over the past seven years this has not been a problem, since there hasn’t been much demand to sell bonds! Interest rates haven’t gone straight down, nor prices straight up, but the clear trend has been higher prices, which rewards buyers, not sellers. Without a lot of volatility or shocks to the system, investors haven’t been running to brokers to sell their bonds en masse.
With interest rates moving up and bond prices falling, it stands to reason that at some point many investors would choose to sell their bonds. Once interest rates stabilize, they’d then try to buy them back at lower prices.
In the past, this was as simple as calling a broker, getting a bid from a bond desk, and confirming the trade. But what happens if there are no traders, or they say they can’t bid on the bonds because it would put them over their trading limit? The bonds would have to be put “on the wire” — which means offering the bonds to other trading desks and investors — in the hopes of attracting favorable bids.
With so many entities shrinking their inventory, it is likely that a rush to sell bonds will overwhelm potential buyers, which would cause bond prices to gap even lower. This could lead to a death spiral in prices, where investors who just want to get out hit falling bids. In this scenario, the price of the entire market for that bond would reset, inflicting pain on everyone else who still holds it.
And it could get worse.
Individuals who hold bonds directly can choose whether or not to take a bid. If the number is too low, investors can step away and come back another day, trying to get more money for their bonds.
But today over $250 billion worth of bonds are held in exchange traded funds (ETFs), which trade like stocks. . When investors are net sellers of ETFs, a few firms can hold some of the excess inventory for a while, but eventually the ETFs are broken up and their individual holdings sold at market prices.
If a lot of bond ETF shares are sold, then a lot of bonds that used to be inside those ETFs will be out for the bid! With big trading firms no longer carrying high inventories, the increased volume of bonds for sale will drive prices down further than they would have in years past.
As the days of 2015 pass and we get closer to the Fed raising interest rates — be it in June, September, or even year-end — investors holding bond ETFs should review what they own. As bond prices fall, ETFs could suffer much greater volatility than expected… because when the call is made to get a bid on the bonds, it’s possible no one will be there to answer the phone.