RESEARCH

Given the less-transparent and less-liquid nature of the OTC trading markets, and given participants’ limited knowledge of the embedded risk therein, market-making is dramatically different than in stock markets. Price discovery, one of the most important features of an efficient capital market, presumes liquidity and sizeable volumes that are available on both the bid and ask side. Additionally, continuous and consistent liquidity is typically provided by a diverse set of actively trading participants. If the number of counterparties that trade becomes limited, markets begin to thin, and a “ghost market” eventually emerges in times of crisis; this is the potentially precarious outcome of the risks in the fixed income OTC markets.

Additionally, just because we did not experience a complete meltdown in a given sector of the bond markets, such as in auto loans during the 2008 financial crisis, does not preclude a meltdown for that sector during the next crisis. The auto loan market proved resilient during the 2008 financial crisis, but this sector has undergone secular changes that have significantly increased its risk profile:

1. The large amounts of capital chasing yields that have flooded this market due to cheap loans; and
2. Originators, responding to the increase in capital, utilizing aggressive techniques to make more loans (e.g., providing consumers longer payment periods or lower rates so they can acquire vehicles they would otherwise be unable to afford).

Lending money to weak borrowers with low credit scores and insufficient means to make payments was the original sin of the subprime crisis in 2008, and similar financial consequences will likely play out again.

Furthermore, these credit crisis indicators are not presently isolated to only the auto sector. As the number of corporate borrowers with a BBB rating rapidly grows and middle-market company leverage increases, there are an ever-growing number of ominous signs. Retail investors’ persistent appetite for innovative products that provide diversification benefits and increased yield has led to the proliferation of corporate bond mutual funds and ETFs. Although the precise allocation to corporate bonds should be calculated carefully, because many of these corporate mutual funds hold a portion of government bonds, the pattern of behavior is clear. Daily liquidity of mutual funds shares may appear to contradict the underlying OTC corporate bond trading liquidity, but the truth will be felt most painfully when we enter a material downturn. The promise of a liquid structure will disappear to the shock and dismay of most retail investors as they find themselves with no exit.

The takeaway here for retail investors is the immeasurable importance of comprehending the hidden dangers in products with asset-liability mismatches. Regulators also need to shoulder the responsibility of taking a proactive stance, rather than merely examining a financial crisis post mortem.

Another ominous sign in the present market is that credit agencies, tasked with accurately evaluating the risks in bond investments, continue to be shadowed by conflicts of interests, because they receive compensation for providing high ratings. Although the Big Three have moved into less controversial and easier to understand credit ratings methodologies, the new rating agencies have entered the markets and are moving towards those riskier issuances. These players are more than eager to gain market share. As a result, BBB securities comprise companies whose rating may not accurately reflect their true risk profile. These companies are likely closer to a junk rating rather than an investment-grade rating.

New regulations of financial institutions from a compliance standpoint, which gained strong momentum after 2008, may prove to ultimately be ineffective. This could be due to the fact that these newly minted compliance officers generally lack the requisite understanding of the market dynamics associated with OTC-trading bond markets and, therefore, possess an inadequate radar to detect and monitor risks.

Given the sheer size of the bond market and its concentration among several players, even the smallest perturbations of uncertainty in the economy or within this market will have substantial detrimental impact. Many pundits believe that financial crises arise from a run on the banks (Gorton 2018). These so-called runs on the bank arise from a lack of trust in the system (Akerlof and Shiller 2009). Essentially, once a counterparty or a client believes that a bank cannot be trusted, they will stop lending to that bank, as happened to Lehman Brothers during the most recent crisis, or the clients will withdraw their money from the bank. It is not a leap of the imagination to believe that a sudden inability to redeem mutual funds and ETFs will rapidly compound the mistrust of financial markets during market distress or give rise to the next enraged Occupy Wall Street movement.

To conclude our examination of some of the most important secular changes in the financial industry since the crisis of 2008, we particularly want to highlight how a lack of trust in the system could accelerate a financial downturn once it has been triggered. These important secular changes can be summarized, from a larger perspective, as a lack of liquidity in the bond market, because each of the secular changes that we examined will be a barrier to price discovery and investor confidence in the fixed income markets.

In this article, we highlighted five areas of secular changes that we believe will exacerbate the next inevitable downturn. What is not inevitable, however, is a financial catastrophe for investors; understanding certain risks can help investors navigate to safer harbors. Although we believe these excesses will fuel many losses in the next downturn, the consequence for investors can be manageable if they carefully consider (and act upon) the secular changes examined herein.

The authors would like to thank Bo Bao, Machine Learning/AI Engineer at SoKat.co, for her helpful editing and technical assistance.