Each morning, the traders at Loomis Sayles’ bond desk rate the degree of liquidity in the bond market, with a rating of one being the worst and 10 the best. Ratings of one or two – as corporate bonds have been receiving of late – are an ominous sign, according to Dan Fuss. “Liquidity is the God of the markets,” Fuss said, adding that he expects to deal with illiquidity for a while.
Fuss spoke last Thursday at the CFA Institute Fixed Income Conference in Boston. He is a vice chairman at Loomis Sayles and has over 50 years of experience in the bond market.
The cause of the recent illiquidity is clear, according to Fuss. Investment banks, who are the primary market-makers for corporate bonds, are reducing their leverage, at least in part because of new regulations, such as Basel III. “Day after day they are being pounded on to get their risk book down,” Fuss said.
A dearth of bonds
Fuss said that spreads have widened, not just for corporate bonds but for Treasury bonds as well. “Our ability to transact on the buying side is far more limited than I ever recall, with the exception of the fall of 2008,” he said. At the height of the financial crisis, his traders rated the liquidity a zero, indicating the market was effectively frozen.
Illiquidity has impaired bond purchases, but Fuss said it has not affected bond issuers. Both corporations and the Treasury have been able to bring new issues to the market.
It is bank deleveraging that concerns Fuss. He said that banks are unwilling to raise equity because of their depressed stock prices. At the same time, they are winding down their “risk book,” selling off assets in order to bring their capital ratios to acceptable levels, he said.
As that happens, Fuss said, it will be akin to a receding tide, exposing rocks that are perilous to navigation. “We don’t see the rocks now,” he said, “and probably a lot of people are not aware of the rocks. For that reason I’m a little bit cautious.”
Fuss said that the dangers he feared most were in the “plumbing” of the banking system, such as the payment settlement and counterparty systems that ensure smooth operation of the banking system.
