How the Bond Market Broke in March

For context, what you should keep in mind is that high yield debt, so called junk bonds, were long thought to be too risky to be held by ordinary investors, but in recent years, as a result of such vehicles as exchange traded funds ETFs and mutual funds, more and more of the market in high yield junk bonds has come to be held by consumers. Ultimately, that raises serious questions about safety and about whether what Boas calls the

alchemy of packaging actually works. This part of the conversation goes really deep behind the story, and I hope that you'll learn as much from it as I did. The dynamics and the market structure changed over the last decade dramatically in a way that I think caused it more or less in March to break. And I don't think that story because bonds are followed far less than the inequities. The bond market breaking for a few days really, to me was one of the most shocking things I've seen

in my career. So let's dive into this moment where the bond market breaks, and I want to take us back to the background. So take us back to when you first started in your business in the nineties. What did the bond market look like that? So I joined Will Street after graduating college in ninety five. I was very influenced by the book Liar's Poker, actually told by

Michael Lewis also Pushkin podcast Maker, among many other distinctions. Yeah, you know, in that story, aside from all the humor, is the point that the participants in the bond market that worked at these banks at the times Solomon Brothers or Now City Group or Goldman Sachs, they were, in their own minds and with the balance sheet given to them by the bank, enormous risk takers and could house a risk if it came to them, they could act as a shock absorber. They didn't view themselves as a

shock absorber if there were too many sellers. They viewed themselves as the world's greatest experts in junk bonds. At that time, there were very few hedge funds, and most of the great credit hedge funds came out of banks, whether they were Drexel, Burnham, Lambert or the ones after. And so if you had a big sell off, really at any point in time, from the nineteen eighties through two thousand and eight, every bank had a trading desk that was there to buy bonds without necessarily needing to

sell them the same day or same week. They could buy them and house them if they felt like they were good investments. So the market makers were investors. And just to clarify that for the civilian, if I'm understanding, you're correctly. What you're saying is if a moment came where people who held bonds thought, oh boy, it's time for me to get rid of these bonds. They're too risky for me and they're more likely to default, and

I'm willing to sell them at a low price. The big investment banks, through their trading desks were like, great, we'll buy them from you at a low price, and then we'll just hang on to them till they are more valuable, and then we'll turn around and we'll make money on it, and we can afford to buy them from you low and hold on to them until the

time comes to sell them higher. And that effectively wasn't their goal, of course, is to make money, But effectively that meant that if there was a sudden moment where most people who held this debt said, oh my god, let me sell it, there was someone there to buy it. Yes, So they provided balance to when there was a supply

demand and balance. They were the demand. And in the last ten years before the global financial crisis, every bank basically had various groups that were not facing customers, that were literally many hedge funds inside of the bank, known as proprietary trading desks, who felt even more able to take on that risk because their mandate was to invest and not to trade with clients. And so you had enormous risk taking capacity at the banks, and that's something

that's measurable. Every week the Federal Reserve reports what the aggregate number of bonds held by the investment banks was at times it was greater than one out of ten bonds was held by these counterparties. And then there came two thousand and seven, two thousand and eight, and everything changed. What happened to all of that death that was being

held by the proprietary trading desks in the crisis. So of course they lost a lot of money in two thousand and eight, and by two thousand and nine, even though they had recovered a lot, and the banks actually posted their best years in history in this sort of trading. The Vulgar rule basically more or less banished that kind of risk taking, not just by the proprietary traders, but

importantly by the market makers. And so if client wanted to sell and the amount was not trivial, the bank was basically, for all intense purposes not there to buy it if it didn't have a ready buyer or it couldn't find one in short order. And so that really changed one side of the market structure, which was we took away the shock absorber, and we took away the

risk taking capacity by the banks. Even though you know, when you think about it, a bank buying the bonds of let's say Boeing a company that's having its own share of troubles right now if it loses money from doing so, is it that different than the bank losing money for making a loan to Boeing. In both cases, they're supporting Boeing in the loan case as a primary lender and in the bond case as let's say, a secondary investor in an actual existing market. But aside from

ought it to be that way. The vocal rule though critiqued at the time by self serving banks, but they might have had a point. We're saying, look, when clients come to sell and the liquidity is very different than it is in normal times, who's going to be there to buy? And so that's one side of the equation.

Can I push on that a little bit? So the vocal rule basically, I mean, I'm oversimplifying it drastically, but it basically said we the government do not want big banks to be sitting on a lot of risky investments because it's nice when they make money, but when they don't make money and they're suddenly losing it, everything can go south very very quickly and bring the financial system with it. If it was an effect of that, maybe even an intended effect of that that the banks couldn't

buy up lots of risky bonds. I mean that sounds sort of like a good thing rather than a bad thing. Are you describing an unintended consequence, which is that they also couldn't be a buffer? Yeah? You know, maybe the answer is something in the middle which would have restrained the amount of risk they could take and therefore money they could lose, but would allow them to some degree to be there when you know there's ten sellers for

every buyer. You know that unintended consequence is something that when you threw out the baby with the bathwater, you know you lost something there and you don't see it in normal times, but you saw it in March. So fast forward now with me to March. You don't have this big buffer. The banks are not capable of buying a lot of bonds when suddenly the prices go down. Suddenly everyone is panicking because we have a pandemic on

our hands. What happened? How did the market break? Well, it's important to know two other things in this story, Okay. One of them is, over the past twelve years since the global financial crisis, the quantity of debt, the capital stock of bonds and loans issued by US corporations went up by about three hundred percent, So the amount of stuff out there held by people grew tremendously. Of course, the banks are not holding hardly any of it anymore.

And the other thing is the question of who held it. So let me just for a second go back to nineteen ninety five. I opened up my first account. I'd started it at Merrill Lynch after college, and I opened up a brokerage account, and I finally think I know a little thing or two about bonds. I've been doing it for a few years in my college summers. That gave me some confidence that maybe was misplaced. And so

I wanted to buy a junk bond. And I remember my Merrill Lynch stockbroker telling me, even though I'm in the business, and I'm in this exact business, that this type of investment is unsuitable for me. I'm not a dentist who doesn't know very much about bonds compared to other things. I'm working at a bank in fixed income. Yet I'm unable to buy a junk bond because it's

considered too risky, too complicated, unsuitable for retail. Now, if you fast forward to March, you have a market three times the size, and the retail investor grew to being the largest investor in the market. Approximately half of all of those bonds and loans are held by retail investors, one way or the other, through myriad of products that are themselves interesting and in some cases responsible for some

of the challenges we saw last month. I don't want to miss out on the punchline story of how the market broke, but I do want to follow your comment about how it came to pass that an investment in a high yield bond, in a junk bond that you couldn't make as an ordinary retail investor nearly twenty years ago now is overwhelmingly where corporate debt is held. So say something about these vehicles, because what you're saying is that all of us basically own a whole bunch of

corporate debt without fully realizing that. So ETFs are the most exchange traded funds are the most famous example, the most salient example. So describe how those work and how they enable people for better or worse. And it sounds like maybe for worse to hold these risky investments that in the olden days people thought were too risky, even for you. Yes, So prior to two thousand and eight, there were almost no ETFs that held junk rated bonds or loans. But what we saw after it was incredible

demand for yields. Global interest rates were cut. We see negative interest rates in Japan, in Switzerland, in lots of places around the world, and there was not enough yields and people needed that to get fixed income, to meet their mortgage payments, whatever it may be. And so there was great demand at a time when stock seemed like

an uncertain investment. The eye popping yields after two thousand and eight, the average junk bond yielded more than fifteen percent, and so that led to horizon products that we're also seeing a tremendous growth themselves, and so exchange traded funds stand out as the most obvious example. But you know, most people are familiar with mutual funds. The story would be the same, and that those funds are special and

that they're open ended. They allow investors to exit every business day of the week, and they allow them to exit almost in almost every instance at what's called net asset value. And so the exchange traded fund goes. So it's a share on the New York Stock Exchange that holds a big pool of assets, let's say junk bonds. Okay, And because investors have a hard time accessing that market, you can't just buy a junk bond. It's not on

the New York Stock Exchange. It requires you know, lots of special knowledge about how to execute in in what's called an over the counter market. So ETFs were seen really as an incredible opportunity. You can give investors one stop shopping where they get access to hundreds of bonds at the same time, whether they were carefully selected by a manager actively managing them, or they represented an index like the Dow Jones or the S ANDP. The growth in that space was enormous, and at the same time

it was also growing tremendously for equities. The problem is that equities are highly liquid investments in ETFs that are promising investors they can get out the same day and are liquid in that big are trading with a difference between the price where you could buy or sell being just a penny. Are holding things that are highly a liquid that at times have a difference between where you could buy and sell at a dollar And so it

raises this question, was this financial alchemy? Did somehow the ETF and the mutual fund being a daily liquidity product, did it solve this iliquidity problem? Did it allow investors to get in and out seamlessly whereas they were unable to before? And of course, from the standpoint of financial engineering, what you want is alchemy, right, you want it to work.

You want to say, well, here is this ordinarily somewhat illiquid asset, corporate debt or sometimes illiquid asset, but we want ordinary people to be able to get access to this high risk debt because they then then get high yields. So if we bundle it in this way, then we can solve the problem somewhat magically. And it sounds like what you're saying is the magic didn't fully work and that it really didn't fully work in March when the market broke. So maybe that brings us to the crucial

moment in March what happened. Yes, so the magic doesn't work if there aren't enough buyers for every seller. So if there is a seller of this ETF and there's a buyer at TTF, no animals were harmed in the filming of this movie, No bonds need to be traded. People can trade the shares of ETF back and forth, back and forth without any bonds being traded, and it's very important to understand that. But at the moment where there's ten sellers for every buyer, and maybe it was

one hundred, which is what happens with retail investors. Retail investors are so procyclical in their behavior. They sell when the market is falling as a group, and they buy when the market is rising. And when they all headed for the exit in March, there weren't enough new buyers

willing to buy, so then what happens. So what happened was there's a mechanism in the ETF meant to make this alchemy work, which is, if ever there's too many sellers, you can just redeem your shares back to the market maker, back to the institution that's overseeing this box, this pool, and they'll go and sell the bonds and they'll give you back your net asset value. So if ever they are not enough buyers, they can go and sell bonds and take the cash from those sales and give you

back your money. But the problem is that the bond market had frozen. It froze for the reasons we've already discussed, and there was just there were no legitimately closed bids for taking that risk near where the price of those shares were, and so we saw a degradation in the price of ETFs way beyond what the underlying bonds would suggest.

And so if you invested a dollar and the pool was worth a dollar, just to put numbers on it, in the biggest ETFs, we saw an extra loss on top of the normal loss of five percent on some days in March, and in some smaller ETFs we saw losses of twenty to twenty five percent on top of

what you lost for the COVID related markets off. And so what happened was basically the market makers step back and said, we're not going to buy these ETFs for what they're worth, because we can't get what they're worth, because that's really the mismatches. We have to give your money today, and it will take us weeks and months, and who knows where we'll get out of those bonds.

And so ETFs basically broke in March, and I think that's what's led the FED to take the extraordinary step of buying high yield ETFs and agreeing to it's you know, even just saying they would do it restored some confidence, but it was done really to just to keep the market from breaking further. When that breaking was happening, was there a contractual violation there? I mean, mom and Pop believed that they could redeem their ETF and the market maker was refusing to do it. So who bore that loss?

I mean, did mom and pop bear that loss? Or did the market maker have to redeem and just do it at a big haircut? So in the initial trades, the market maker felt like, okay, i'll buy them at any V and that asked value, I'll buy them slightly lower, But at some point they just kept buying them. And when something is for sale, without the market maker being able to offload the risk, they'll take a step back.

What's supposed to happen is arbit treasures are supposed to step in and say, i'll buy a dollar for ninety five cents, I'll take on these portfolio bonds. I'll sell them myself. But again, in a broken bond market, people didn't have confidence of that, and that's where things really went off the rails. What's the regulatory solution to that?

I mean, you could imagine two directions. One is the insurance model that the government will give some insurance, which is de facto what actually happened, But that seems to create terrible incentives because then people will take on all kinds of risk they shouldn't take because the government's effectively

guaranteeing their investment. The other option would be to say, well, g maybe these ETFs can't be over the counter retail products sold to mom and pop if they're not actually capable of sustaining asset value at a moment when people run for the run for the hills. So in that theory, you know, maybe we should go back to the days when you couldn't buy junk bonds because it's actually too risky for mom and pop. You know, as much as people don't want to talk about going backwards, I think

we did go too far in the other direction. And it really was the perfect storm of retail being too big a player in the credit market. And I only mentioned we only mentioned two products. I mean, there are products like collateralized loan obligations, closed end funds, business development companies that all faced a similar fate. Even if they didn't all have to sell on day one, they all had issues like margin calls and things that all fed

into this. And so you know, the answer is probably somewhere where there is a regulatory limit on the amount of high yield credit risk that should be in daily liquidity funds, because it really is illusory, this idea that this thing that is so tricky to get in and out of gets packaged into a daily liquidity vehicle. It's really in some ways unsuitable. And it doesn't matter if it's not very big, but when it becomes the biggest player,

it's incredibly important. One crucial question that emerges from this part of the conversation that I had with Boas is the regulatory question of whether, going forward, it's still safe for ordinary investors to hold mutual funds ETFs or other vehicles that expose them to substantial risk from high yield corporate bonds from junk bonds. The losses that took place in the market were not only a product of everyone

wanting to sell at the same time. They also revealed, as Boas suggests, an underlying decline in the value of the assets held by the ETFs or their mutual funds below what their aggregate value should have been, even in a falling market. That's a puzzle, and it's a puzzle that's going to have to be solved not just at the conceptual level, but at the practical, real world regulatory level. I hope you enjoyed this special bonus conversation, and until I speak to you next time, be careful, be safe,

and be well. Deep background is brought to you by Pushkin Industries. Our producer is Lydia Jane Cott, with research help from zooe Win and mastering by Jason Gambrel and Martin Gonzalez. Our showrunner is Sophie mckibbon. Our theme music is composed by Luis Garratt. Special thanks to the Pushkin Brass, Malcolm Gladwell, Jacob Weisberg, and Mia Lovell. I'm Noah Feldman. I also write a regular column for Bloomberg Opinion, which

you can find at Bloomberg dot com slash Feldman. To discover Bloomberg's original slate of podcasts, go to Bloomberg dot com slash podcasts. And one last thing. I just wrote a book called The Winter, a Tragedy. I would be delighted if you checked it out. You can always let me know what you think on Twitter about this episode, or the book, or anything else. My handle is Noah R. Feltman. This is deep background