RiverPark Funds Q1 Letter: Corporate Bond Market TransparencyVW Staff
RiverPark Short Term High Yield Fund and RiverPark Strategic Income Fund commentary for the first quarter ended March 31, 2015. Also see some recent comments on AT&T debt in Barron’s.
Thirty?eight years ago, the Delaware Bay froze over and stayed frozen for 45 days, a record that stands today. With boyhood enthusiasm, I told my parents I was going to walk over the bay from New Jersey to Delaware. As I sprinted out, I heard subtle cracking sounds as the ice shifted from my weight and briefly stopped to reconsider my actions. It was just enough time for my father to catch up and warn me that, while the ice may be miles wide, it was probably not thick enough to support me on my quest. This was an early lesson in weighing risk versus reward.
The 2008 financial crisis highlighted systematic risks which prompted the U.S. Government to pursue regulation and policies to protect citizens from future hazards and jump?start a recovery from the “Great Recession”. The reforms aimed at “Too Big to Fail” institutions and implementation of “Quantitative Easing”, have definitely restored a sense of stability, but not without unintended consequences. In March 2015, the Bank of International Settlements and Moody’s Investor Services highlighted the adverse impact on bond market liquidity and the consequences of low interest rates which encourage companies to lever up.
RiverPark Funds: Corporate bond market transparency
The plethora of new financial regulations has increased corporate bond market transparency and breadth at the expense of market depth. The financial crisis forced Wall Street to deleverage and unwind proprietary trading positions. The “Volker Rule” sealed the fate of the business model, permanently curtailing market making activities in favor of agency transactions. In other words, Wall Street would no longer serve as a provider of liquidity, but would be more than happy to continue to take an order and match buyers and sellers on a best efforts, riskless, basis.
Addressing the concern head on, the Bank of International Settlements discussed in their recent quarterly review the “Shifting tides – market liquidity and market?making in fixed income instruments”7:
… in most corporate bond markets, trading appears to be highly concentrated in just a few liquid issues, and concentration appears to be increasing in some market segments…In many jurisdictions, marketmaking has thus shifted from a principal trading model towards a clientdriven brokerage model. As a result, many market?makers have become reluctant to absorb large positions and consequently need more time to execute large trades.
RiverPark Funds: Unintended consequences of new regulations
Despite the best of intentions, every new regulation and intervention has unintended consequences. The First Law of Thermodynamics states: Energy can neither be created nor destroyed; it may only be controlled, stored or transferred. Similarly, the Volker Rule did not eliminate systemic risk. Instead, the risk was transferred from Wall Street to its institutional clients, the “Buy Side”. Prior to the 2008 financial crisis, Wall Street trading desks actively engaged in market?making activities and their inventory represented a significant portion of the corporate bond market. A recent Greenwich Associates survey highlights the liquidity void; 38% of buy?side fixed income participants surveyed felt that trading $15MM or more (par value) bonds was extremely difficult.
This begs the question: Are investors being adequately compensated for this risk? With interest rates at historic lows, finding yield without taking on significant risk can be difficult. It has long been our belief that smaller issues of “money good”, high yield bonds offer investors a high risk?adjusted rate of return.
RiverPark Funds: High yield market
Splitting the high yield market in half by issue size illustrates the significant yield pick?up. The bottom 50% of issues has an option?adjusted?spread (“OAS”) over US Treasuries of 582 basis points (“bp”) which is 140 bp more yield per year than the top 50% of issues. Coincidently, excluding the energy sector because of recent turmoil and potential future credit losses, the bottom half of issues still maintain an advantage of 140 bp OAS:
Over the past 15 years, investing in an index of the bottom half of issuers would have outperformed the top half of issuers by a cumulative 50.1% in return.
We know there is no free lunch… general consensus is that smaller issues are less liquid than bigger issues. This is not always the case. For instance, in periods of great market stress, we have observed that the larger issues quickly become as illiquid as the smaller issues. Below is a chart illustrating the difference in OAS between the top 50% and bottom 50% of high yield issues over time:
See full PDF below.