Fixed Income Recap

Treasuries were mixed today. The short end sold off as the two-year dropped 1/32 of a point in price while the ten-year traded higher by half of a point. The benchmark curve was flatter on the day by 10 basis points. A basis point represents .01%.

MBS reversed trend today and widened considerably to Treasuries. MBS as a whole underperformed the rest of fixed income as investors struggle to accurately price the Fed’s participation in the market. These wild jumps can be expected when prices are propped up artificially. Thirty-year 5% mortgages were 20 basis points wider to Treasuries after tightening 55 basis points over the past month.

The Four Primary Risks of Bonds

Credit
Duration
Liquidity
Structure

A liquid investment is one that can be bought or sold in a timely manner without a significant movement in the price. Liquidity is often measured by “the bid-ask spread”, or the difference between the price at which someone is willing to purchase or sell a security.

Highly liquid Treasury bills have a very small bid-ask spread. As I am writing one can sell four-week T-bills at 99.980 and buy them at 99.983. The .003 spread is negligible. T-bills benefit from having an ample supply and many market participants, who are constantly buying and selling, therefore providing liquidity. Bid-ask spreads can range from almost nothing to 10% of the price or more, depending on a variety of factors.

In general, bonds are less liquid than stocks simply because of the breadth of the bond market. A company that has one common stock traded on the NYSE can have hundreds of different corporate bond issues that trade independently of each other. More issues of smaller size translate into less market participation per issue and less liquidity.

Many investors buy bonds with no intention of ever selling, meaning they can take added liquidity risk, and often earn additional return for doing so. But liquidity can change quickly, along with your intentions of holding a bond to maturity.

Liquidity risk has been in the news a lot recently. Financial institutions that invested in highly complex, hard to value credit derivatives are seeing the value of those investments decrease due to the lack of liquidity in the market. Banks all across the country are taking huge hits due to illiquidity in their securities portfolios, and their solvency, as defined by their regulatory body, is at risk as a result.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst