The Great Credit Illiquidity Myth

Christopher Joye

Coolabah Capital

For years I have been told that secondary corporate bond, or "credit", markets are illiquid and difficult to trade in. The problem is that anyone who actively trades credit knows that this is a myth. Last month I put $500m of new money to work in credit in a matter of days with little-to-no impact on bid-ask spreads or our transaction costs. The myth is purveyed by buy-and-hold managers that cannot be bothered to get active when it comes to credit, preferring instead to punt interest rate derivatives; those who are running money in competing sectors (eg, overseas bonds); and by asset-allocators that are pushing portfolio solutions that for some bizarre reason don't have exposure to domestic credit even though they are loaded to the gills with the no-more-liquid Aussie equities.  Click on this link to read the column for free: 

"Let's start by considering the relative size of Australian fixed income compared to a better known asset class like Aussie shares. According to the ASX, the total value of listed companies is $1.8 trillion. The Australian bond market is a similar size, although you would never know it if you looked at asset allocations within super funds, which massively favour leveraged local equities over safer debt. The value of investment-grade Australian debt securities (in all currencies), which means bonds with ratings ranging from BBB to AAA, is about $1.5 trillion, which rises to over $1.6 trillion if you include unrated and sub-investment grade bonds, and hybrids. If you then add in "direct loans" and corporate debt held on bank balance sheets, you would find that the Aussie fixed-income sector is, in fact, larger than listed equities. Roughly $1.3 trillion of the $1.6 trillion of Aussie bonds are issued domestically. The non-government bond or "credit" market, encompassing financial and corporate bonds, is worth about $844 billion of which close to $600 billion is issued in Aussie dollars (including investment-grade hybrids). Primary liquidity in the bond market, or the annual value of new issues, is multiples the size of equivalent ASX IPOs. Whereas shares are perpetual, bonds have hard maturities that need to be regularly refinanced irrespective of conditions. On average, there are around $20 billion to $30 billion of new IPOs on the ASX each year. By contrast, the annual value of domestic bond issuance is $140 billion. So what about secondary trading? The ASX says that cash market trading was worth $1 trillion in the 2016 financial year. This means that the Aussie sharemarket's turnover ratio is about 57 per cent. In a 2016 speech the Reserve Bank of Australia's Guy Debelle published the secondary turnover ratios for different sectors of the bond market over time. This was based on all data available from Austraclear, which accounts for Aussie dollar bonds only. Debelle also excluded all primary issues. Across government bonds, the secondary turnover ratio is 250 per cent to 300 per cent, which translates into $1.8 trillion each year. Within corporate debt markets, the turnover ratio is similar to equities at about 50 per cent. That means secondary volumes in Aussie credit amount to $250 billion to $300 billion annually (or over $5 billion per week), which increases to more than $400 billion if we add in Aussie credit in foreign currencies. Secondary trading in Aussie fixed income is therefore about 2.2 times the size of domestic equities...As far as liquidity goes, high-quality credit markets have some big advantages over shares. Many non-government bonds are eligible for the RBA's liquidity facilities, including senior-ranking securities issued by banks and AAA rated securitisations. This means that the public sector stands ready to buy this paper in all circumstances, which is not a privilege afforded to equities. It is also very easy to execute large, say $25 million to $50 million, parcels in highly rated credit (eg, the major banks' senior debt) without affecting bid-ask spreads." 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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