No Liquidity, No Cash, No Fun

How many times have I said it?: Watch your ass in the cash market for corporate bonds.

And I don’t mean because both IG and HY are absurdly rich. Or because we’re (probably) near the end of the cycle. Or because IG and HY issuers are sitting on near record leverage.

I mean because in a pinch, you (or in most investors’ case, a fund manager) might not be able to sell the damn bonds in a pinch because there’s no liquidity in the secondary market. I strongly encourage you to familiarize yourself with this problem by taking a few minutes to read one of the most viewed posts in this site’s short history, “Liquidity Lapse: Don’t Say You Weren’t Warned.”

Those who have read that piece or who are intimately familiar with the market will recall that money mangers and investment advisors specializing in corporate credit are moving away from the cash bond market and into individual name CDS and/or CDX indexes. Why? Because they’re more liquid than the cash market. Here, look:


(Chart: NY Fed)

Well for anyone who needed confirmation of this trend, here’s some confirmatory color from UBS.


For those wishing to retain long HY exposure, we have a strong preference for CDX HY over cash bonds. First, market structure increases the risk of an illiquidity-led selloff in physical HY bonds. 31% of the US HY market ($405bn) is held within mutual funds, and this number balloons to 71% ($922bn) when including separately managed accounts (Figure 17). This far outstrips other US credit markets. In a more volatile macro world, cash selling from funds can lead spreads to gap beyond fundamentals. This is what happened in early 201612. We believe mutual funds will shift long exposure from cash bonds to synthetic CDX when volatility increases, even if directional views on spreads are unchanged13. This was certainly true in discussions with clients in late 2015 as the high-yield market widened. Lastly, don’t be fooled by the increase in prices; dealer surveys through Q4 indicate that high-yield secondary market illiquidity has deteriorated significantly, with no improvement despite last year’s rally. (Figure 18)


Oh, and here’s the worst part: you see how there’s no market for these bonds (right pane above)? Well when people start selling the ETFs, you’d better hope fund managers aren’t depending on cash balances to meet redemptions, because…



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