BIG INVESTOR: The one thing markets have been fearing isn't actually going to happen

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Portia Crowe

Sat, Sep 5, 2015, 9:36 PM

(REUTERS/Brendan McDermid)
Everyone has been getting bond market liquidity all wrong.

People have been getting bond-market liquidity all wrong.

That's according to Krishna Memani, the chief investment officer and head of fixed income at investment-management firm OppenheimerFunds, which manages around $220 billion.

For months, word on the Street has been that a liquidity crunch could be coming, and that investors and traders would wind up selling bonds in an illiquid market, causing prices to plunge and interest rates to skyrocket.

Everyone, from JPMorgan chief Jamie Dimon to Blackstone billionaire Steve Schwarzman to bond guru Bill Gross, has sounded the alarm about the lack of liquidity in the bond market.

But, according to Memani, their fears have been overblown, and here's why:

The past wasn’t as rosy as people make it out to be; the trigger for the crash is unlikely to occur, and the real risk is something else entirely.

We used to measure liquidity all wrong

"I think people look at the period of 2000 to 2007 ... and look at that as the golden period of market liquidity, but that is misinterpreting liquidity," Memani told Business Insider.

He said that during that period, US banks were sourcing "credit protection" — meaning securities like credit-default swaps that offset credit risk — from European firms. That allowed the US banks to match bonds with that protection, which, in theory, reduced their own risk and allowed them to run huge trading books.

(Photo courtesy of OppenheimerFunds)
Krishna Memani, chief investment officer and head of fixed income at OppenheimerFunds, says we don't need to worry about bond-market liquidity.

"But that wasn't true liquidity," Memani said.

Proprietary trading leading up to the 2008 financial crisis also increased so-called dealer inventory, or the amount of bonds investment banks held on their books.

But Memani said banks having a lot of inventory is not the same as having a liquid market, as a lot of that inventory was not available for trading.

"I think that's just looking at a wrong metric to come to a conclusion," he said.

Proprietary trading has since been effectively outlawed through the Dodd-Frank Act's "Volcker Rule," which bans, among other things, short-term proprietary trading of securities and derivatives.

That has in turn reduced dealer inventory. Memani says those who blame the Volcker rule for reducing liquidity are missing the point: It was never that liquid anyway.

"Telling people that the markets are less liquid today because of Volcker is perhaps overstating the case," Memani said.

The reality is that bond markets — particularly the market for corporate bonds — have always been less liquid than markets for other instruments like equities or foreign exchange, according to Memani.

(REUTERS/Jonathan Ernst)
Paul Volcker, after who the Volcker Rule is named.

It's literally irrelevant

The much-cited trigger for a bond-market-liquidity crisis — that investors rush to sell as rates start to rise and bond prices fall — is also much less of a risk than has been made out, according to Memani.

The world is in a process of deleveraging, Memani says. The gradual withdrawal of incredibly accommodative monetary policy will likely lead to instability and less risk-taking.

That means it is unlikely that investors will pull hundreds of billions of dollars from relatively safe bond funds and invest, instead, in stocks.

"You are buying bonds not because you want to get rich — you buy bonds because you want it to hold value," he said. "And they sure as hell will hold value a whole lot better than equity if bad things happen in the market. I can't figure out why that would get them to withdraw hundreds of billions of dollars."

Plus, he said, when rates do start rising, they're only going to rise "modestly" for a very long time.

(Scott Olson/Getty Images)
No one is panicking and going all-in on stocks once interest rates start to rise.

The real issue

The real issue, Memani suggests, is simply that investors tend to "herd" together in the credit markets.

Investors in the bond market are much more likely to move in lockstep than those who invest in the equity market. That means when credit investors either want to buy credit or sell instruments at various points in the economic cycle, they tend to want to do it all at the same time.

"So I think it's that that creates the volatility in the markets, not the fact that the markets are less liquid or more liquid," he said.

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