BlackRock's paper-issuing arm issued a pretty interesting paperthis week on bond standardization.1 Basically: there are a lotta bonds, and none of them trade and it's impossible to get the size you want of the bond you want, and this could be solved by each issuer only having, like, three bonds, and re-opening them when they need to borrow more money, instead of creating new bonds all the time. Each issuer has only one stock, mostly, so why can't they cut back on the bonds a bit?
Also all the bonds should mature at the same times, preferably like IMM dates, to make hedging easier. And to make everyone refinance at the same time. What fun those times would be. September 20, 2008, for instance, five days after Lehman filed for bankruptcy, would have been a rough time to have to refinance bonds.
The argument is pretty straightforward. Bonds don't trade very much:
Driven by investors' preference to trade the newest issue from any company:
And by dealers' increasing unwillingness, driven by capital requirements, risk aversion, and the Volcker Rule, to hold inventory:2
If issuers standardized bonds, so that an AT&T, for instance, had only a handful bonds rather than the 74 it currently has outstanding,3 then someone wanting to invest in AT&T credit could pretty much just invest in AT&T credit, at one of a few standard curve points, rather than having to seek out a big chunk of a relatively small and illiquid off-the-run bond. If AT&T wanted to raise more 5-year money, it could reopen a 10-year it issued five years ago. If it only issued a 10-year four years ago, it'd have to compromise a little.
Obviously there are competitive reasons for BlackRock to favor this sort of thing. Competitive with other money managers, for one thing: BlackRock is basically in the business of buying all the bonds; hedge funds that are in the business of convergence trades or reading weird covenants or whatever might disagree on the need for standardization. As BlackRock puts it, "Investors need to weigh new issue gains and strategies exploiting liquidity differences versus the ability to trade in size"; their own priorities are clearly on one side.
Competitive with other infrastructure providers, for another: BlackRock is sort of imaginarily in the business of providing an electronic customer-to-customer trading system for bonds, which would compete with dealers. Standardization would help with that effort: you can't have a functioning crossing network if everyone is looking for different bonds, but if everyone is trading just a few bonds, you can cut dealers out of the equation. And save, um, 3.5% of your spread income:
BlackRock is also aiming to cut dealers out of bond issuance and let issuers sell directly to its electronic trading platform:
A key cost for issuers is the issuance process itself. Underwriting fees average 43 basis points for top IG issuers. ... A potential shift toward (cheaper) auctions of new issues would likely go hand in hand with standardization. Previous attempts at auctions have failed, but improved technology, insatiable investor demand and dealer retrenchment could create a new catalyst.
Still the fact that they're self-interested doesn't make them wrong. Investors have shown a preference for standardization and liquidity in a lot of contexts, like exchange-traded products, or CDS as a single uniform way to invest in a corporate credit, or for that matter CDS futures as a more liquid and standardized way to invest in CDS. And electronic standardized trading would probably be more efficient than telephone trading by inventory-light dealers. (Though, I mean, some people aren't so jazzed about the efficient standardized electronic trading in the equity markets.)
But: so what? A basic dynamic in capital markets goes like this:4
Investor: Your new thing should have Feature X.
Issuer: We don't like Feature X. It gives us less flexibility.
Investor: Well, we like it, and we're the ones buying your bonds.
Issuer: So you're saying you won't buy our bonds if they don't have Feature X?
Investor: No, obviously we'll buy your bonds. But we won't be happy about it.5
Issuer: Oh, okay, but of course you'll buy the bonds at a lower spread if they do have Feature X, right?
Investor: Umm. I mean, we want our spread, too.
As your terrible MD would say, the answer to the question "higher yield or better structural features" is "yes!"6 The paper has vague noises about how standardized issuance will be cheaper for issuers - those direct-to-investor auctions for one thing - but also a lot of concrete noises about how it'll be more expensive. Investors dislike above-par reopenings, for one thing, meaning that if you issued a 10-year five years ago when Treasury yields were like 200bps higher and want to reopen it now at 110, investors will charge you a higher spread than they would if you just did a new five-year bond.7
So there's not much appeal for issuers here: they can get less flexibility, more complexity, and scarier maturity walls, in exchange for higher interest costs. BlackRock thinks that this may change in the future: today's "issuer nirvana may not last" as rates go up, and one day issuers may need to give BlackRock what it wants. Maybe they'll even save some money in exchange.
1.An earlier version of this sentence read "BlackRock's paper-issuing arm issued a pretty interesting paper this week on OH GOD ON ISSUING PAPER THE PUN WAS NOT INTENTIONAL I SWEAR." Anyway if you like wretched puns or whatever there you go.
2.Ooh here is a pie chart of dealer inventories:
How do you feel about pie charts? And how do you feel about that one?
3.They've got a table listing a bunch of worse offenders (GE with 1,014 bonds, Citigroup with 1,965, JPMorgan with 1,645, etc.), but those are financials so shouldn't really count.
4.Often intermediated by bankers (not shown).
5.Or "yes, that's what we're saying, we won't buy your bonds," followed by buying the bonds anyway. It's a stylized dialogue.
6.That's what he says, right? Even though it makes no sense. It's an "or," "yes" is a meaningless answer. He means "both!" Maybe he says that, I don't know, I've never met your terrible MD. I'm just guessing.
7.Because of the bankruptcy claim thing (if a premium bond defaults you only get a par claim in bankruptcy). Also issuers hate it for tax and accounting complexity.
Another thing that might make the standardizing plan more expensive is the thing I mentioned at the beginning, about maturity walls:
Kashif Riaz, a member of BlackRock’s global capital markets team, acknowledged at the briefing that a key concern among dealers was the potential of “concentrating refinancing risk,” rendering huge batches of debt due for repayment on similar dates.
So they have a way around that; from the paper:
To mitigate this, the bonds could include an option for issuers to call the debt in the three months prior to maturity.
Shouldn't call options cost money? (No, sort of kidding, obviously they don't. But they should.)