Blain's Morning Porridge, Submitted by Bill Blain of Mint Partners

Why we should be very nervous about corporate bonds

“Before the fiddlers have fled, before they ask us to pay for the bill and while we still have the chance.…”

This might be week the proverbial chickens have more need than ever of somewhere to recover from the last 9 years of frothy market madness. Take a look at the signs and signals – the Nikkei taking a 1000 point spanking last week, the US stock market looking wobbly on the lack of any real prospect of tax reform (my stock chartists have picked though the graphs, and see sell signals everywhere), articles saying Europe is poised on the edge of an economic boom-time (which, by the laws of financial common sense means its about the tumble back into recession…)

And then there is the UK – where sterling is in flight on rumours of a no confidence motion in Theresa May.. FFS.. Does the fact a confidence vote might be on the cards actually mean there are still people who have any confidence in her? I though we all understood how this plays out? I though we all agreed she is absolutely the worst possible leader of the conservatives and worst ever choice for prime minster, with the notable exception of any other elected conservative MPs?

Very interesting research note from a US investment banks says there is a 40% likelihood of a Labour Corbyn government by 2022. The risks of an election are elevated by the party spilt/civil war on Brexit, but also on May fundamentally misreading the leftwards shift in UK electoral attitudes – the Tories need a socially liberal leader to win an election. (I’ve got the phone number of the other Milliband brother if they are interested.)

It’s increasingly looking likely, says the bank, May may have to agree an electoral pact with the SNP to stay in power, meaning a second Scottish independence referendum and soft Brexit adding even more uncertainty for Sterling. (I disagree, I think the SNP know they won’t win a referendum now, but will “bide” their time waiting for the opportune moment, and simply demand a state of the art hospital for every Scottish village, payout for university fees, and other sweeteners to keep the unelectable May in power.)

Back in the real world, I was looking at a very interesting graph over the weekend. On one axis is the remorseless rise of the US$ corporate bond market -outstanding volume has risen from $2.5 trillion in 2001 to $5.5 trillion today. Overlaid on top was the volume of corporate securities held by the investment banks/primary dealers to promote liquidity in the corporate bond market was shown. Since the Global Financial Crisis (GFC) inventory has absolutely crashed - the amount of dealer liquidity supporting the market has tumbled from about $300 bln in 2008 to less than $30 bln today. A 90% drop! Just as well markets have been so resolutely bullish!

Consider these points carefully.

Reflect particularly on how the last 9 years of the massively benign but utterly distorted bull corporate bond market has changed fixed income fundamentals and warped how business is transacted across the credit markets. It’s difficult to conclude anything but 10-years after the GFC, fixed income markets are less robust and more likely fracture under pressure.

Everyone is aware all markets have been distorted by QE. Central banks have blitzed some $15 trillion onto their balance sheets via monetary experimentation - draining liquidity while injecting cash thus causing spreads to tighten. Interest rates have reached record lows and stayed there extending the bull rally, while defaults have been rarities..

What is more insidious is the way markets have evolved during this false phase, and the unintended consequences of QE in changing the functioning of the bond markets.

Back when I was a fixed income banker, running DCM origination at the investment bank of a global behemoth, we won corporate bond mandates on a number of key factors: how well we understood the market, how tightly we would price (my deal winning song: “Libor plus 2, Libor plus 2, you know it’s for you!”), how well we could demonstrate demand and, critically, how well we support the issuer’s market reputation by providing secondary liquidity in the bonds.

While the old days were far from perfect, contrast them with today. There is almost zero support for any bond beyond the immediate primary market. If you need to sell any bond position, you are utterly reliant on your bankers acting as a broker - seeking a bid. Banks get away with it because ... that’s what they say the regulations say.

Today’s issuer is far less concerned with the picture a deal presents. They care about getting money at close to zero rates so they can use that cheap money to fund equity buybacks. It’s been a rare issuer that’s launched bonds to actually build new plant or spend on CapEx. Leverage has risen, but who cares when money is cheap... And if inflation kicks in, what do they care – it benefits borrowers!

The second aspect of looming bond market crisis is the changed relationship with the buy-side investors. In my day we had to compete to get into the top 5 for each and every client - knowing 80% of the clients business would be done with its top relationship bankers. Today, most clients will be lucky if there are even 3 banks calling them with ideas, views and news.. And the power in the relationship has swung - rather than salesmen courting investment managers for attention, young freshly minted bankers call up expecting polite investors to fawn upon them in order to receive favourable new issue allocations.

Most business still goes to the banks on the basis they’ve persuaded clients they “know the bond best” - although increasingly Brokers like ourselves here at MINT are changing the secondary flow patterns.

There has also been massive consolidation. JP Morgan (a superb institution) dominates Fixed Income. Effectively the fewer top names comprise an oligarchy. League tables hardly matter when there are realistically only a few names in the global frame. (When I started work in the mid-1980s there could be 100 banking names on a deal tombstone!) Most fixed income entrants of the last 10-years will have absolutely no idea what a tombstone was... or what a tumbling market feels like.

Yet the banks are increasingly profitable in the fixed income space. Corporate bond market making has collapsed for a number of reasons. The most obvious is regulation - the powers making sure banks can’t be overextended with risky inventory by piling up capital charges and reigning back “risk activities”. That was great news for investment banks. By dropping market making, their daily VAR (Value at risk) has declined by around 90%. Nothing unusual about banks profiting from regulation at the expense of their customers.

So, what we have is more concentrated market, with diminished liquidity, limited expertise, and a disturbing non-alignment of interest between the buy and sell side. Does that bode well for long term stability?

Nope.