The “end of the world” scenario is a frequent explanation for market volatility – even for bonds. Government bonds generally benefit from a “flight to safety.” Those who already own the bonds get a nice little capital gain. Those who fled get, well, generally their money back, but not much in the way of interest.
And for those who own non-government bonds – the haircuts can be startling – as we are seeing in the Greek bond threnody.
But why would corporate bonds react so violently in “flight to safety” situations. Are they all going to go bankrupt at the same time? About this time last year, Barry Allen, founding partner at Marret Asset Management, commented that investors were pricing in defaults of the likes that had not been seen since the Great Depression – even though, outside the financials, corporate balance sheets were in pretty good shape.
A recent Bank of Canada study, written by Alejandro Garcia and Jun Yang, tries to decompose investor response. “Since the beginning of the credit crisis in mid-2007, corporate spreads worldwide widened markedly,” Garcia and Yung note. “In Canada, the aggregate spread for investment-grade firms reached a maximum of 401 basis points (bps) in January and March of 2009, substantially more than the historical average of 92 bps; the spread on the equivalent index in the United States reached 656 bps in December 2008, also substantially more than its historical average of 153 bps. Owing to the problems in funding markets, corporations and financial institutions began to replace ‘risky’ assets with ‘safer’ ones; this ‘flight to-quality’ effect resulted in large price declines in equity and corporate bond markets and increases in prices in the government market.”
It would be expected that investors fearful of default would first ditch high-yield bonds and then later investment-grade corporates. And that’s what happened. But, while junk bonds fall in and out of favour, why the gapping out on investment-grade bonds?
It turns out that not only is default risk operating, but also liquidity risk, Garcia and Yung argue.
“[T]he corporate spread reflects the additional compensation required by investors to hold the corporate bond compared with the return on the default-free asset (the government bond). This additional yield compensates investors for two types of risk: (i) the risk of default, i.e., that the firm may not be able to meet the promised cash flows; and (ii) the liquidity risk, i.e., the risk that the investor may not be able to sell the bond quickly, before it matures, without a significant discount to the existing market price.”
File this under efficient markets, with a sub-tab for liquidity providers.