Goldman on Bond Market Volatility

Goldman Sachs credit managers expect sharp price movements in high-yield bonds if there are substantial outflows from funds holding such debt.  The volatility is greater than it would be otherwise because bank prop desks and broker-dealers have responded to impending regulatory changes, in particular the Volcker Rule of the Dodd-Frank Act, by getting out of the market or reducing their inventory.

“The lack of depth in the market exaggerated market volatility from the swings in fund flows,” says a Goldman Sachs commentary. “In advance of impending regulatory changes, broker-dealers de-risked their books and were carrying much lighter inventories of high-yield corporate bonds.”

As a result, buyers and in particular sellers of the bonds are left in a market where there are few that can take the other end of the trade.

The Goldman managers expect extreme swings to continue: “The inability and unwillingness of broker-dealers to be a provider of liquidity resulted, and may well continue to result, in our view, in more dramatic price swings going forward.”

Money has been flowing to fixed income assets—including fixed income hedge funds, among the sectors attracting the largest inflows in the past 12 months according to TrimTabs and BarclayHedge. With interest rates at historic lows, investors seek yield, hence the intermittent popularity of high-yield bonds.

On the other hand, when investors get into the risk-averse mode, they want to move away from high-yield debt, otherwise known as junk bonds. Uncertainty arising from the European debt crisis continues to cause risk-off episodes of outflows from high yield.

Market makers’ withdrawal in response to new regulations exacerbates the impact of investors’ risk-off, risk-on moves.

The Goldman managers write that “participants in the corporate credit markets do not fully appreciate the lack of depth available to support the high yield corporate bond market in the event of material outflows.”

Tags: BarclayHedge, Dodd-Frank Act, Goldman Sachs, TrimTabs, Volcker Rule