Back Flip Into Liquidity

Financial models are a glorified method of interpolation

-Emanuel Derman

Recently Dan Davies wrote about bond market difficulties. Bonds are so heterogenous they have never been an easy sell.

Imagine, you are a real estate agent. Part of your job is valuing houses.

How would you value a house in a neighbourhood which have had a bunch of similar houses (each one has a pool) sold every month?

Easy, right? Floor size is important, plus or minus a bit depending on the specific location.

Now an unusual house comes across your desk, a pool-less house.

The valuation becomes more difficult.

This is the key problem with derivative pricing.

Options are valued with respect to equities and treasuries. Corporate bonds are valued with respect to treasuries.

Illiquid securities are broken into more liquid securities.

So in our pool case, perhaps we find the average value add of pools nationwide and approximate.

Either way, houses with pools are more liquid and priced better.

So what happens when one market becomes more liquid than another?

If most of the sales begin to be for houses without pools, they become easier to price.

That may happen some day with corporate bond markets.

Corporate bonds have two major components. Interest rate and credit related payments. They can be broken down into treasury bonds (very nice collateral) or repos and short credit default swaps.

Currently the global bond market is worth $100tn and the Credit Default Swap market is about $25tn.

With very broad strokes, we can measure up the sovereign bond portion versus the corporate. The single name corporate CDS versus the government CDS markets, and see how close sovereign bonds plus corporate CDS are to outweighing the corporate bond market size.

Once the inequality does flip it will be more efficient to sell CDS than buy corporate bonds.

CDS are atomic, unlike other derivatives they can't be decomposed.

Options can be broken into components or replicating portfolios but CDS can be used as part of a replicating portfolio for more complicated instruments!

If CDS were conceived before corporate bonds, I doubt there would be a reason for corporate bonds to exist.

Similarly, being able to choose a house and a pool independently is far more valuable than having both lugged into one package.

This upshot would be less bond sales hokum pokum and better functioning credit markets for everyone but the middlemen.