Investing in the secondary debt market
Although many bond investors employ a “buy and hold” strategy, there are circumstances when they may wish or be forced to sell bonds before maturity. The secondary bond market is the marketplace where investors can buy and sell bonds. A key difference compared to the primary market is that proceeds from the sale of bonds go to the counterparty, which could be an investor or a dealer, whereas in the primary market, money from investors goes directly to the issuer. For a more detailed explanation of the secondary bond market, please click here. In this article, considerations for secondary market trading will be explored.
Bonds have a par value and market value. If an investor holds a bond to maturity, the principal amount repaid by the issuer, provided the issuer does not default, is the par value. However, when an investor sells a bond prior to maturity, the proceeds received reflect the bond’s market value. The market value is the price a counterparty is willing to sell or buy a bond for in the secondary market. The market value can be significantly different from par value based on a number of factors such as interest rate risk, liquidity risk, call risk etc.
Since bonds are generally traded over-the-counter (OTC) by dealers, transaction costs are not standardized like they are for equities traded on an exchange. Instead of upfront commissions (i.e. $0.05 per trade), like for equities, bond transaction costs are embedded into the dealer’s bid-offer spread. These transaction costs can be referred to as “markdown” or “markup”. A markdown or markup is the cost in excess of the “market” bid-offer that the buyer or seller of the bond is charged by the dealer. For example, markdown would be a reduction of the bond sale price from its current market bid price, where the current market bid price is the price the dealer could immediately resell the bond to another dealer. The markdown or markup varies based on different types of bonds and different dealers. As markdowns and markups are embedded in the bid-offer spread, it can often be difficult for investors to accurately determine transaction costs.
Most transactions in the secondary bond market are facilitated by dealers. Historically, dealers held large inventories of corporate bonds on their balance sheets, which allowed them to provide liquidity support for the secondary market. However, during the last decade, increased regulation (e.g. Volcker Rule, Basel Regulatory Frameworks) and a corresponding decrease in risk appetite of most dealers, has driven a decline in dealer’s bond inventories and adversely impacted market liquidity.
Post global financial crisis, regulators across the world have recognized the significance of creating a safer banking system. A series of regulation reforms have indeed made most financial institutions more resilient. However, those new regulations also resulted in some unintended consequences particularly for the secondary bond market liquidity:
Basel III: Requires banks to fund themselves with at least 4.5% of common equity (compared to 2% in Basel II). The minimum Tier 1 capital has been raised to 6% (compared to 4% in Basel II). While less levered banks are safer, they are also less incentivized to make a market due to higher capital requirements, especially in the capital-intensive bond markets. The result is a sharp decline in bond trading activities of banks' dealer arms, and subsequently falling market liquidity.
Volcker Rule: Prevents banks from proprietary trading activities, which is trading securities with their own funds, thereby discouraging speculative investments made by banks that led to 2008 financial crisis. The unintentional outcome on bond markets is that banks are less capable of being a powerful intermediary due to the shrinking bonds inventory. As a result, banks are increasingly acting as an agent to look for buyers when an investor wants to sell his bonds. Not surprisingly, the execution time is longer and big price swings are more frequent, even among the most liquid bond securities such as 10-year US treasury.
Dodd Frank Act – Collateral Requirements: More collateral will be needed as most transactions require dealers to post initial margin. Secondly, collateral eligibility standards will become much tighter; only high quality and highly liquid assets such as G7 government bonds or major currencies can be used as collateral without any haircut whereas riskier corporate bonds are either ineligible or have to take a haircut. Therefore, banks are becoming more reluctant to hold large amounts of bonds to provide market liquidity.
Dodd Frank Act – Clearing, Reporting, and Testing: A major reform of Dodd Frank in clearing is that most bilateral trades will be cleared mandatorily through a central counterparty. In terms of reporting timing, current T+1 model will be replaced with T+0, which means initial margin will need to be pre-funded and further increase the demand of collateral for banks. Annual stress testing will also be conducted by regulators to ensure banks’ balance sheet is robust enough to withstand market crashes.
In a nutshell, all of factors discussed above make the intermediary cost significantly higher for banks. A decline in market liquidity is the natural outcome. Nevertheless, financtial technology solutions such as Overbond platform can mitigate reduced market-making capacity of dealers as well as reduce the intermediary cost by bringing bond market participants together more efficiently.