RETHINKING FIXED INCOME
A Stacked Deck

Describing events in the bond market in 2008—and their future implications—is a bit like describing the construction of a house of cards. Each card was carefully placed to support another—until one card trembled and the whole structure collapsed. The difference is that everyone understands the fragility of a house of cards, but few saw the interrelatedness of fixed-income securities, the exotic investments they spawned and the broader economy. A second difference: The bond market is not permanently disabled—it is on its way to returning to more-normal functioning; however, the players and the rules have changed.

Bond Market Structure

It helps to understand the structural differences between trading stocks and trading bonds. Stocks trade on electronic or bricks-and-mortar exchanges where buyers and sellers converge in a central meeting place and transact with anonymity. Bonds trade on an over-the-counter market using an intermediary, such as a bank or broker with full knowledge of the trade counterparty. It’s similar to trading in your car with a car dealer, which then looks for a buyer. The dealer is taking a position and risking its capital. It must hold the bonds in its inventory until it finds a buyer.

Holding inventory can become an expensive proposition if there is no buyer. Bonds are much less liquid than stocks in normal times; in fact, only a very small percentage of outstanding bonds trade daily. When markets are stressed, buyers for many bonds disappear. This is what happened in 2008, and it had a cascading effect. Once the buyers of bonds disappeared, the market makers—who were themselves de-leveraging—became unwilling to function as intermediaries providing liquidity in credit markets. 

Add to that a domino line of failed financial players (Countrywide Financial, Bear Stearns, Fannie Mae, Freddie Mac and Lehman Brothers were the first casualties), and you get a market that ceases to function as a source of liquidity.

A Bad Hand

The casualties mounted as it became clear that the market’s evolution toward exotic financial products was not the risk-management feat that many had thought it was. To understand this development, recall first that yields on fixed-income investments have been relatively low for more than a decade (10-year Treasury notes have yielded less than 6 percent since 1998). One way to boost yields—and attract billions of dollars—is to reduce the perception of risk. The financial industry created a raft of products that appeared to do so. 
Collateralized debt obligations (CDOs), for example, were packages of lower-quality bonds and mortgage-related investments in which dealers and banks sold off tranches of securities with similar risk characteristics. The theory was that spreading risk among a larger number of investors, and grouping the riskiest cash-flow streams into their own tranches, reduced systemic risk. Because these CDOs offered attractive yields in a low-rate environment, hedge funds, pension funds, banks and brokers bought them by the hundreds of billions of dollars.

The deals were packaged to suggest to rating agencies that the worst credits had been separated into subordinated debt, freeing the balance of the CDO for higher ratings. In addition, there was a view that defaults were independent events; therefore, building a portfolio of low-quality but separate issuer bonds reduced risk. Little transparency existed regarding the underlying securities in each debt package, and cross-default correlations, for reasons mentioned, were understated. As a result, CDOs received much higher ratings than they merited. Part of the problem was risk assumptions that didn’t take into account the series of events that would follow if housing prices collapsed. The failure of the models to capture the risk building in the system means that what once was a triple-A-rated CDO with a two- to five-year average life now trades at 40 cents on the dollar.

Credit default swaps (CDSs), which are insurance against default by a bond issuer, also appeared to reduce risk without impairing returns. However, sellers of credit protection (most notably American International Group) were hammered as the economy slowed, and bank and brokerage credits weakened to the point of numerous bankruptcies. AIG had viewed CDSs as another diversifier in its array of insurance products; however, when financial firms failed and credit spreads widened significantly, AIG was unable to pay claims on the large volume of credit default contracts it wrote.

As the true risk behind CDOs and CDSs came to light, they tumbled in value, turning profitable lenders and investors into financial train wrecks overnight. Even corners of the bond market not tied to mortgages were drawn into the crisis. Many insurers of municipal debt had strayed into these exotic products, wrapping their bonds in insurance in an attempt to secure credit at lower prices. The credit ratings of the insured bonds were tied to the ratings of the insurers, which had billions of dollars of exposure to the CDO market. So now there was uncertainty over the value of insured municipal bonds: Was the insurance any good if bond insurers started failing? Suddenly municipal debt, traditionally seen as a safe investment backwater, seemed unstable. In addition, many of the structured municipal money market investment vehicles ran into stress. These issues relied both on the bond insurers’ high credit quality and a bank’s ability to provide liquidity. When both of these backstops became questionable, many of these structures unwound, leading to additional forced selling in municipal bonds. 

Bond exchange-traded funds also were affected in September and October, when unusually large gaps opened between their market price and the underlying net asset value (NAV). This happened for two reasons. First, the illiquidity of bonds, particularly corporate bonds, made it difficult to accurately price them when buyers disappeared. An ETF’s NAV is based on the assessed value of the individual bonds that the ETF holds, so if those values are in doubt, the validity of the NAV comes into question. In this case, the buyers and sellers of the ETFs took a different opinion of the value of the bonds the funds were holding, pushing the share price of the ETFs below their stated NAVs. The ETFs were reflecting the fact that prices received upon selling actual bonds were, on average, lower than the best estimates of pricing services. 

The reduced liquidity of the underlying bonds resulted in greater discounts for ETFs in the investment-grade and high-yield corporate markets (less-liquid markets) than for ETFs tied to more-liquid government Treasuries; the discounts were largest for ETFs with hard-to-trade baskets (i.e., too many issues and a creation unit with par amounts that were too small to transact at near bid-side prices).

Cracks In The Foundation

So far we have seen that systemic issues in bond markets created a fertile environment for liquidity problems in a market upset—and that financial innovations over the past decade made it considerably easier for problems to grow. But cracks in the foundation under this house of cards had long been building.

In the first half of this decade, an asset bubble was forming. Low mortgage rates and increasing liquidity caused home prices to rise, creating demand for first and second mortgages and home equity lines of credit. Mortgage brokers loosened credit standards so that money flowed to even the weakest borrowers—further driving up home prices. Similar trends developed in commercial real estate. The securitization of these loans meant the party could keep going as long as investors were willing to ignore the underlying risks, which increased with each subprime loan. This phenomenon produced huge profits for proprietary trading desks at commercial banks, hedge funds and the investment banks that packaged and sold these securities. 

How did everyone miss the risk that was building throughout the system? Stock market volatility has been below market norms for much of this decade. Many risk models give heavier weight to data from recent periods because “that’s the market we’re in.” Using such models, institutional investors took more risk by levering up to capture the returns they sought; however, their notion of risk was based on an inaccurate reading of potential future volatility. When volatility returned to the markets, their risk assessments rose. But when they tried to de-lever by selling securities, they discovered they were holding investments that had become illiquid overnight.

Investors Regain Aversion To Risk

In August 2007, problems in the subprime market started to surface. The investing public was shocked to learn how many segments of the market were compromised by the subprime house of cards. For example, some money market funds had acquired exposure to subprime loans by buying commercial paper from structured investment vehicles (SIVs). Many SIVs were partial investors in subprime loans, using short-term commercial notes to finance their purchases. When the loans soured, that short-term debt—which many money market managers thought was rock solid—became heavily discounted. Combining these SIV-type price declines with other market-related defaults eventually led one money market fund to “break the buck” and others to seek help from parent companies to prevent such trauma. Fearing a run on the trillions of dollars in money markets, in late 2008, the federal government extended deposit insurance to money market funds. 

When money market funds ceased to look safe, investor attitude toward risk shifted from highly tolerant to highly intolerant. From August 2007 until the end of 2008, we saw a massive unwinding of leverage. Hedge funds, investment banks and others that had borrowed heavily to boost their assets at risk in the market now had to unwind their investments—selling into a declining market—to meet margin calls from their lenders (when pledged assets fall in value, additional collateral must be pledged to a lender).

The Waves Ripple Out

Much of our economy is built on debt—whether a person borrows to finance a house, car or college education, or a developer borrows to build a skyscraper or a manufacturer borrows to finance its inventory. Banks and brokers have fed that appetite for debt by securitizing these assets, and in many cases, carrying them on their own books. The collapse of mortgage securities (assets) was followed by a collapse in banks’ share prices (equity). To balance their books, banks have had to raise capital (as many did from foreign government funds or from new U.S. equity offerings), and/or reduce assets (i.e., loans and other investments). The rapid decline in loan volumes has cut off the lifeblood of economic growth. In addition, banks have raised their lending standards so much—an extreme reversal of the excessive decline in standards earlier—that credit is available only to the most highly rated borrowers. 

Banks have also been forced to take unwanted liabilities onto their balance sheets. For example, the aforementioned SIVs were created by banks to invest in mortgages and asset-backed securities. When the SIVs were unable to sell short-term commercial paper, the banks had to step in and cover the debt. Additionally, as the commercial paper market dried up, borrowers were forced to tap their lines of credit at banks. This contingent borrowing forced banks to increase leverage at a time when they sought to decrease it (leverage measures the ratio of a bank’s liability to its capital).

As mentioned at the start, the bond market’s structure depends on banks and brokers to provide liquidity and make markets. We have seen all the major brokers become banks to access government money and deposits, while the banks are selling inventory and shedding risk—the opposite of what market makers do.

One measure of how bleak things got in September and October is bid/ask spreads. Typically, a dealer would pocket a 5-basis-point spread on the sale of a 5-year bond yielding 5 percent. That spread shot up to between 40 and 100 basis points last fall when buyers disappeared.

‘We Are Here To Help’

Since then, the government has taken numerous steps to counteract a breakdown in the financial system:

• The Troubled Asset Relief Program injected equity into banks. That reduced the pressure to de-lever as a result of shrinking equity.
• The FDIC temporarily backed bank bonds with a maturity of up to three years, providing access to a cheap source of funding. The term may now be extended to maturities of up to 10 years, due to the long-term nature of the financial system’s problems.
• The U.S. Treasury Temporary Guarantee Program provided a temporary guarantee to money market investors.
• Regulators played a significant role in managing the collapse of IndyMac, Fannie Mae, Freddie Mac, Lehman and AIG, and in the mergers of Bear Stearns, Merrill Lynch, Wachovia and Washington Mutual.