Tuesday, November 18, 2008

The New Order

Much has been made of the November 15 deadline for many hedge fund clients to submit redemption requests. While we wait to see what the eventual impact of this will be, let's consider how the changing nature of leverage has altered the the bond market. Bear in mind that fixed income arbitrage was among the most popular hedge fund strategies. In addition, it was a core strategy for many dealer prop desks as well as the foundation of the CDO market. The decline of leverage may permanently alter the nature of fixed income spreads.

Fixed income arbitrage is, at its core, fairly simple. Start with a bond that yields x% (over and above some hedge in some cases), assume one can borrow y% of the par amount at a cost of z%. If the math of all that works out to a reasonable IRR on the residual, the arbitrage works.

These arbitrage accounts were the marginal buyers in the fixed income markets. As long as the arbitrage remained attractive, yields (or yield spreads) would remain within a narrow band. When an investor wanted to sell a bond, even if there was no long-term buyer at the ready, arbitragers would step in and provide liquidity. In this way, leveraged buyers were ensuring that the market remained efficient. Spreads would only meaningfully widen when credit risk increased.

We know it went too far. CDO^2 and SIVs were the most obscene examples. But even reasonable arbitrage strategies, like TOBs and CLOs became too large as a group. They stopped just being the marginal buyer and became the whole market.

That marginal buyer is gone, and isn't likely to come back any time in the foreseeable future. Admittedly, it isn't as though leverage is being pushed to zero in the fixed income markets, but haircuts (i.e., the amount of margin that must be posted) are now such that levered buyers cannot force efficiency. Take something simple like Fannie Mae 5-year bullet bonds. Should have a very small spread versus Treasuries given the government backing of the GSEs, but instead the spread is currently around 1.45%. It seems like an arbitrage.

But in order for an actual arbitrager to realize a decent IRR on the trade, it probably needs to be leveraged 20x or so. Now maybe one can actually get that amount of leverage versus Agency collateral, but what happens if the trade initially goes against you? The potential margin calls would kill you. Its a difficult arbitrage to actually realize.

The consequences for investors are far reaching. First, bonds will be permanently less liquid. Dealers will be going away from making money via bond arbitrage and go back to making money on transaction flow. In order for that to be viable, the bid/ask spread is going to have to stay much wider than in 2006. Odds are good that trading volumes will also remain much lower than was the case in 2006.

Second, yield spreads will probably remain more volatile than in years past. This is because real money buyers, like mutual funds and banks, will become the marginal buyer of bonds. The technicals of real money demand will suddenly become much more important in determining short-term spread movements.

Third, new debt issues will need to have a greater concession to secondary trading in order to get sold. Take a look at Thursday's 30-year Treasury auction to see what I mean. Primary dealers aren't able to keep Treasury auctions orderly in a world where Treasuries in general are in hot demand. The result? The 30-year Treasury priced about 2.5% lower in price than where it was trading the previous day. By Friday morning, it had regained all that it had lost. The same thing will happen to new issue corporate, municipal, and even agency bonds of large size.

In the short term, what should investors consider in bonds? If banks, mutual funds, and other long-term investors are going to be the new marginal buyers, buy what they are going to want. That is high quality, high yielding bonds. This means longer-term or bonds with option risk, such as callable agencies, municipals, and agency mortgage-backed securities.

Finally, if liquidity is going to remain challenging, buy bonds you are comfortable owning for the long-term. If you do buy a corporate bond, assume that it will cost you 3-5% of the bond's value to sell at short notice.

5 comments:

tom brakke said...

I wrote yesterday about there being "too many arrows" (in the diagrams of the structured finance deals we saw). Great thoughts from you on the implications of some of them going away.

cap vandal said...

Maybe institutions will be more interested in buying real bonds instead of synthetic bonds or other structured finance monstrosities.
I never understood how synthetic bonds, cdo's, etc. actually benefitted the real economy. I suppose there is some theoretical justification of reducing basis risk for buyers vs. there liabilities. We don't know where home loans will end up, but although I can't prove it, a portfolio of intact, undeconstructed loans has to be worth more then equivalent structured finance securities. If for no other reason then vanilla, whole loans can be carried at amortized value less allowances. Further, people have a pretty good idea of the range of reasonable values for a traditional mortgage.
OK....I suppose enough people have piled on to structured finance so there is no need to continue to kick them around.

I suppose I'm wondering if a pension fund manager in 2009 might just try to buy real bonds in the market, which now is paying for liquidity, instead of screwing around with portable alpha strategies.

Roger said...

AI - Do you think that in some way the carry trades and ridiculous leverage used in the fixed-income arena provides an explanation why the credit markets are so much more pessimistic than the equity markets? I mean the leverage of 30 to 1 seen in Enhanced Leverage hedge funds betting on all kinds of mortgage-backed crap and LBO debt pales in comparison to the leverage use by equity long-short funds. Consequently, the equity markets look sanguine compared to the credit markets with their blown out CDS spreads, but in reality, the credit markets are where a lot more of the ridiculous trades and schemes were carried out. This gets played out in credit market estimates of the depth of the recession versus S&P earnings decline estimates.

alex said...

What do you think of the idea that agency spreads are higher because Paulson has refused to say they carry the same guarantee as treasuries?

Accrued Interest said...

Cap:

I agree that a "real" bond is worth more than a synthetic just about all cases, because the "real" bond holder's legal position is more clear. The synthetics were more liquid during the good times because they were more generic.

Roger:

I think the bond market was never priced like this kind of sudden liquidity freeze was possible. Not that the stock market had it figured out, but at least stocks always priced in the possibility of a crash. I think the biggest challenge in stocks isn't figuring out earnings going forward (challenging tho that may be) its figuring out multiples.

Alex:

That's part of it. In fact, I'd say that the reason why they widened yesterday but it doesn't explain why they are so wide to begin with. Paulson can't make the gty explicit without Congressional action, because I believe it would impact the debt ceiling. Now its possible that Congress acts on this at some point, but wouldn't expect it until after the new administration.