Securities are for growth. Bonds manage risk. This has been a traditional investment mantra for years. In recent days, however, that mantra has been getting harder and harder to live by. Institutional investors are buying them up in droves, driving the prices up. What are they doing?
The answer has a lot to do with financial regulation. Part of what drove the financial crisis of 2008 was speculation in unlisted securities through so-called “over-the-counter trades,” those not conducted through one of the big exchanges. Investment companies and dealers were trading privately, leading to market volatility. One answer to this was to mandate all trades take place through a central clearinghouse.
Of course, in order to make sure sellers get paid in a timely fashion, these clearinghouses have to keep buyer money on hand in the form of margin. Think of it like a savings account at a credit union. It’s money you have to have stored there to use the services of the institution. The credit union can’t take too many chances with that money, since you could ask for it back at any time. The same is true for the margin stored at clearinghouses.
If they just kept the money in cash, they’d risk losing it to inflation. Plus, they wouldn’t be able to afford to keep the lights on or their staff employed. They need to generate some income from the money, but can’t afford to take serious risks. So, they invest the margins they hold into very low-risk vehicles. Mostly, this has focused on sovereign debt, including US treasury bills.
Of course, low-risk is not no-risk. If the underlying currency loses value quickly, the international clearinghouse system would be unable to make exchanges. This would turn a national crisis of currency into an international crisis of liquidity.
This increased debt buying has been happening alongside a long-term pattern of quantitative easing. That’s the practice of central banks buying up their own nations’ debts. Both of these forces have placed serious upward pressure on the highest grade bond prices.
However, as the global economy enters a more robust growth cycle, quantitative easing may come to an end. This, coupled with tighter regulation on clearinghouse trades, could hit the bond market hard. Savvy investors should watch these stories carefully.