Liquidity and the Trump Trade

The United States Treasury department has floated a new idea to improve liquidity in the market for treasury bonds, which has been a concern ever since the Volcker Rule came into place.

The basic problem with liquidity in the bond market is that there are a large number of similar instruments trading, which leads to a fragmented market. This is a consequence of the issuer (the US Treasury in this case) issuing a new bond every time they wish to borrow more money, and with durations being long, many bonds are in the market at the same time.

The proposed solution, which commentators have dubbed the “Trump Trade” (thanks to the Republican Presidential candidate’s penchant for restructuring debt of his companies), involves the treasury buying back bonds before they have run their full course. These bonds bought back will be paid for by newly issued 10-year bonds.

The idea here is that periodic retirement of old illiquid bonds and their replacement by a new “consolidated” bond can help aggregate the market and boost liquidity. This is not all. As the FT ($) reports,

The US Treasury would then buy older, less liquid and therefore cheaper debt across the market, which could in theory then be reissued at a lower yield. In recent months, yields on older issues have risen more than those for recently sold debt, suggesting a deterioration in liquidity.

This implies that because these “off the run” treasuries are less liquid, they are necessarily cheaper, and this “Trump Trade” is thus a win. This, however, is not necessarily the case. Illiquidity need not always imply lower price – it is more likely that it leads to wider spreads.

Trading an illiquid instrument implies that you need to pay a higher transaction cost. The “illiquidity discount” that many bonds see is because people are loathe to holding them (given the transaction cost), and thus less people are willing to buy them.

When the treasury wants to buy back such instruments, however, it is suddenly a seller’s market – since a large number of bonds need to be bought back to take it off the market, sellers can command a higher spread over the “mid price”.

Matt Levine of Bloomberg View has a nice take on the “IPO pop” which I’ve written about on this blog several times (here, here, here and here). He sees it as the “market impact cost” of trying to sell a large number of securities on the market at a particular instant.

Instead the typical trade of selling, say, $1 million of a bond with $1 billion outstanding, and paying around 0.3 percent ($3,000) for liquidity, you want to sell, say, $1 billion worth of a bond with zero bonds outstanding. That is: You want to issue a brand-new bond, and sell all of it in one day. What sort of bid-ask spread should you pay? First principles would tell you that if selling a few bonds from a large bond issue costs 0.3 percent, then selling 100 or 1,000 times as many bonds — especially brand-new bonds — should cost … I mean, not 100 or maybe even 10 times as much, but more, anyway. No?

Taking an off-the-run bond off the market is reverse of this trade – instead of selling, you are buying a large number of bonds at the same time. And that results in a market impact cost, and you need to pay a significant bid-ask spread. So rather than buying the illiquid bond for cheap, the US Treasury will actually have to pay a premium to retire such bonds.

In other words, the Trump Trade is unlikely to really work out too well – the transaction costs of the scheme are going to defeat it. Instead, I second John Cochrane’s idea of issuing perpetual bonds and then buying them back periodically.

These securities pay $1 coupon forever. Buy these back, not on a regular schedule, but when (!) the day of surpluses comes that the government wants to pay down the debt. Then there is one issue, with market depth in the trillions, and the whole on the run vs. off the run phenomenon disappears.

People don’t worry enough about liquidity when they are trying to solve other liquidity worries, it seems!


Ratings and Regulations

So the S&P has finally bitten the bullet and downgraded US federal debt to AA+ from its forever rating as AAA. While this signals that according to the S&P US Treasuries are no longer the least-risky investments, what surprises me is the reaction of the markets.

So far, since the rating change was announced after US market hours on Friday evening, only one stock exchange has traded – the one in Saudi Arabia, and that has lost about 5%. While it can be argued that it is an extension of severe drops in the markets elsewhere in the second half of last week, at least a part of the drop can be explained by the US debt downgrade. Now, when markets elsewhere open tomorrow after the weekend, we can expect a similar bloodbath, with the biggest drop to be expected in the US markets.

Now, the whole purpose of ratings was supposed to be a quick indicator to lenders about credit risk of lending to a particular entity, and help them with marking up their loan rates appropriately. It was basically outsourcing and centralization of the creditworthiness process, so that each lender need not do the whole due diligence himself. You can argue in favour of ratings as a logical extension of Division of Labour. If lending is akin to making shoes, you can think of rating agencies analogous to leather tanners, to save each shoe maker the job of tanning the leather himself.

However, over the course of time, there have been two consequences. The first was dealt with sufficiently during the global crisis of 2008. That it is the debt issuer who pays for the ratings. It clearly points out to an agency problem, especially when the “debt issuers” were dodgy SPVs set up to create CDOs. The second is about ratings being brought into the regulatory ambit. The biggest culprit, if I’ve done my homework right, in this regard was the much-acclaimed Basel II norms for capital requirements in banking, which tied up capital requirements to the ratings of the loans that the banks had given out. This had disastrous consequences with respect to the mortgage crisis, but I’ll not touch upon that here.

What this rating-based regulation has done is to take away the wisdom of crowds in pricing the debt issued by a particular issuer. Normally, the way stock and bond prices work is by way of wisdom of crowds, since they represent the aggregate information possessed by all market participants. Different participants have different assumptions, and at each instant (or tick), they all come together in the form of one “market clearing price”.

In the absence of ratings, the cost of debt would be decided by the markets, with (figuratively) each participant doing his own analysis on the issuer’s creditworthiness and then deciding upon an interest yield that he is willing to accept to lend out to this issuer. Now, however, with ratings linked to capital requirements, the equation completely changes. If the rating of the debt increases, for the same amount of capital, the cap on the amount the banker can lend to this particular issuer jumps. And that means he is willing to accept a lower yield on the debt itself (think about it in terms of leverage).

Whereas in the absence of ratings, the full information known to all market participants would go into the price of debt, the presence of ratings and their role in regulation prevents all this information flowing out to the market in terms of the price of debt. And thus the actual health of the issuer cannot be logically determined by its bond price alone – which is a measure that is continuously updated (every tick, as we say it). And that prevents free flow of information, which results in gross mispricing, and large losses when mistakes are discovered.

I don’t have anything against ratings per se. I think they are a good mechanism for a lay investor to get an estimate of  the credit risk of lending to a particular issuer. What has made ratings dangerous, though, is its link to banking regulation. The sooner that gets dismantled the better it is to prevent future crises.