Liquidity in the Bond Market Michael Surowiecki, CFA

PIMCO

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2

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Biographical information

Michael Surowiecki, CFA

Mr. Surowiecki is an executive vice president and portfolio manager in the Munich office, with a

focus on LDI portfolios and interest rate derivatives. He previously served as head of the

European quantitative strategies desk and was also a member of the rates analytics group. Prior

to rejoining PIMCO in 2011, Mr. Surowiecki worked as a derivatives trader for BNP Paribas and

Fortis Bank, where he held positions in principal strategies, as well as exotic and vanilla rates

trading. He has 17 years of investment experience and holds a master's degree in financial

engineering from the University of California, Berkeley as well as an undergraduate degree from

Lehigh University.

Introduction

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What is liquidity?

For illustrative purposes only. Source: Commoditytrademantra.com

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Definition of liquidity

Liquidity is the degree to which an investor can buy or sell…

Asset Quality …an underlying asset or a security with a certain quality

Time

Price …without affecting the asset's price,

…and within a specified time frame

Quantity …a certain quantity of

Source: PIMCO.

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Have regulations impacted market liquidity?

Source: TBAC, MSNBC, The New York Times, The Wall Street Journal

8

Central bank

•Provides: Money market liquidity

•Activity: Depo, repo, lending rates, haircuts, LTROs, etc

Sell Side ("Investment Banks")

•Provides: Bond market liquidity

•Activity: Primary and secondary market making

Buy Side ("Investment Funds")

•Provides: Fund liquidity

•Activity: Daily redemptions and contributions

End Investor

•Economic choices: Consumption, investment, savings, etc ....

The bond market "liquidity chain"

ZIRP

NIRP QE

Dodd-Frank

Basel III

EMIR

Mifid/ir

/ / /

/ /

/

/ / /

/ /

/

/ / /

/ /

/

• Post-crisis regulations have had an impact at every step along the bond market's "liquidity chain"

• While regulations have made the system generally safer and more resilient ....

• .... this has come at the cost of reducing market liquidity and efficiency

Source: PIMCO

Measuring market liquidity

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Instantaneous liquidity in the secondary market has a price

• The price of (instantaneous) liquidity increases with the size of the transaction (chart 1)

• It fluctuates over time due to market conditions (chart 2), e.g. positively correlated to market volatility

Chart 1: Liquidity cost increases with transaction size

Chart 2: Liquidity cost varies over time

For illustrative purposes only. Source: PIMCO

Large

transactions

cost more

Peripheral

debt crisis

Global

financial

crisis

11

Measuring the cost of liquidity:

Transaction Cost Analysis (TCA) ....a conundrum?

Chart 3: (Very) large tickets have "cost" less than small tickets ...?

Chart 4: Buy tickets have "cost" less than sell tickets ...?

Chart 1: Lower rated bonds are more costly to trade

Chart 2: Cost of liquidity has decreased steadily since the crisis

For illustrative purposes only. As of October 2018. Source: PIMCO

Lower quality

= less liquid

Liquidity has

"cheapened" since

the 2008 crisis

Why do large

tickets cost less

than small

tickets?

Why do "buy"

tickets cost

less than "sell"

tickets?

Regulatory impact on market liquidity

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Post-crisis reforms have made the banking system more resilient...

Chart : Dealer inventories are at decade lows, while the amount of bonds is at record highs

Banks Keep Cutting Bond Traders as One-Third Gone Since 2011”

– Bloomberg, May 2016

Credit Suisse To Exit European Securitized Product Trading,

Distressed Debt Markets”

– Forbes, March 2016

Royal Bank of Scotland to exit U.S. mortgage business”

– Reuters, November 2014

JPMorgan said to cut credit traders amid emerging-market

swings”

– Bloomberg, March 2016

Barclays To Discontinue Trading In Non-Agency U.S. Mortgage-Backed

Securities”

– Forbes, June 2015

The Supplementary Leverage Ratio is discouraging banks from investing in the safest

assets. We would urge that the SLR be dialed back”

– BPEA, Sept 2017

Regulatory changes have made it more expensive for

banks to hold large inventories of bonds which has hindered

their role as liquidity providers in fixed income markets”

– Financial Times, Sept 2018 As of October 2019. Source: PIMCO, New York Fed, Deutsche Bank

0

50

100

150

200

250

300

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19

USD bln USD trn Primary dealer inventory of corporate bonds (rs)

Total stock of US corporate bonds outstanding (ls)

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...and primary markets have become important windows of liquidity for end investors

Chart 1: Growing importance of primary market as "liquidity event"

Chart 2: Decreasing presence by primary dealers

For illustrative purposes only. Source: JP Morgan, Bloomberg, PIMCO, CNBC, Financial Times, Bloomberg

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Traditional relative value relationships have permanently changed...

If your shareholders expect RoE of 10% to 15%, would you allocate balance sheet to this trade?

Trade: Buy US Tsy and Pay Fixed 30y Swap

Pre-crisis P&L:

Position: Carry: Notional:

Buy 30yr US Tsy +44 mln 2.0 bln

Pay Tsy Funding -37 mln 2.0 bln

Pay 30y Swap -36 mln 2.0 bln

Rec 3M Libor +40 mln 2.0 bln

= Total Profit +11 mln

Post-crisis P&L:

Position: Carry: Notional:

Buy 30yr US Tsy +2.20% 100%

Pay Tsy Funding -1.85% 100%

Pay Swap -1.80% 100%

Rec 3M Libor +2.00% 100%

Funding for IM -2.50% 10%

Liquidity Buffer -2.10% 8%

= Return on Capital +1.30%

Chart: US 30yr Treasury yield (red) and US 30yr swap rate (blue) since 1995

Capital

For illustrative purposes only. As of October 2018. Source: Bloomberg, PIMCO

Structural break...

from positive to

negative

Bond yield minus swap rate

("swap spread"):

US 30y bond yield (red)

US 30y swap rate (blue)

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Bond "Magic" :

How liquidity transforms negative yields into positive returns

Chart: Yield curves for Cyprus (red) and France (blue) Which bond shall we invest in?

Cyprus 10y at +0.60% yield

France 10y at -0.16% yield

• If we hold the bonds to maturity, Cyprus will

outperform France based on yield to

maturity.

• However, in a stable yield curve

environment, France can outperform

Cyprus on a "total return" basis

• This is possible because French bonds are

significantly more liquid and can be "rolled"

on the steep yield curve

• In the example on the left, the high trading

cost due to low liquidity would reduce total

return for Cyprus to ~+0.20%

• As such, due to lack of liquidity, Cyprus has

to be held and cannot be "rolled".

For illustrative purposes only. Source: Bloomberg, PIMCO

Choosing the more liquid bond keeps your portfolio safe without compromising total return

Investment implications

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Low and slowing economic growth

Elevated valuations

Lower yields for longer

Higher volatility

Challenging liquidity conditions

Volatility

Returns

As of May 2019. Source: PIMCO.

Cyclical Outlook: Window of Weakness

19

Secular Outlook: Dealing with Disruption

Five secular trends that have the potential to disrupt the global economy, financial markets

and investors’ portfolios in the next several years

Technology Populism Demographics China Financial

Market

Vulnerability

As of May 2019. Source: PIMCO

Focus

today

20

Implications for portfolio structure

• Be selective and cautious on the outer perimeters

of PIMCO's concentric circles (figure 1)

• Choose liquidity over yield, defense over offense

• Provide liquidity, rather than ask for it

• Focus on capital preservation

• Scale positions conservatively and diversify

• Preserve dry powder to take advantage of opportunities

• Yield up

• Liquidity down

Figure 1: PIMCO's concentric circles of market structure

Source: PIMCO.

Questions

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

Hypothetical example

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual

results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all

of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Outlook

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and

each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

Risk

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest

rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate

environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than

the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate

significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a

position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market,

economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be

enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of US government agencies and authorities are supported by varying degrees, but are

generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than

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Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and

exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income

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not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.

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