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Junk yields are junky

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Good morning. I have a sneaking suspicion that some of you are going to disagree with today’s second item, about payment for order flow. If so, you know where to find me: robert.armstrong@ft.com

Real euro junk yields are not negative so much as pathetic

On Tuesday the FT reported the following, under the headline “Real yields on European junk bonds go negative for first time”:

The yield on ICE BofA index of European high-yield bonds was pushed down to 2.34 per cent this week, marking the first time buyers of so-called high yield European currency bonds have accepted payments below consumer price inflation in the eurozone, which hit a decade high of 3 per cent in August.

All true, but if I buy a junk-rated bond with (say) five years to maturity, I don’t care about the inflation rate now; I care about the rate of inflation over the next five years. And expectations for inflation in the eurozone over the next five years are lower than 2.34 per cent. As of Thursday, according to the five-year five-year euro inflation swap, inflation is expected to run at 1.75 per cent over that period. The junk yield has surged back to 2.4 per cent, leaving a princely real junk yield (the nominal yield minus expected inflation) of 65 basis points.

Tomas Hirst of CreditSights made this point on Twitter, pointing out that euro junk traded at slightly lower real yields back in 2017:

My question for him was, yes, real yields are positive, but how is anyone going to make money buying this stuff with 65bp of real yield? This seems bonkers. He said:

You are not jumping up and down saying there is great value here. We all understand that if defaults pick up, that is a problem, because you are not being compensated for that . . . you are not even being compensated for supply risk. We think there is a lot of leveraged buyout financing coming — perhaps €25bn to €30bn worth — and a lot of that is going to hit the B tier [the second-highest rung of high yield] . . . It doesn’t take a lot to make investors say, do we want to own this stuff, or do we want to own the stuff that is coming to market, which has to pay [a higher yield]?

We live in a world priced for very, very, very low returns.

Payment for order flow: the case for who cares

It is weird that my retail broker gets paid for giving my stock order to another company to execute. Why should my little order be worth paying for, unless I am being taken advantage of? I mean, in a poker game, if I don’t know who the sucker is, the sucker is me.

Sheila Bair, the former chair of the US Federal Deposit Insurance Corporation and a persistent regulatory gadfly, thinks I am, in fact, the sucker. Here she is, writing in the FT on Wednesday:

Critics say payment for order flow, or PFOF, represents an inherent conflict of interest, sensibly observing that brokers should be routing orders where they can get the best price for their customers, not the best deal for themselves.

Supporters argue that PFOF benefits retail investors, as market makers are required to provide prices that are better than quotes displayed by regulated exchanges. They add that broker profits from PFOF allow them to offer commission-free trading.

But it is far from clear whether PFOF actually reduces costs for retail investors, or simply makes their costs less transparent. By allowing market makers to attract order flow with a lawful bribe, not a best price, PFOF gives them every incentive to hide the true price at which they are willing to trade, probably leading to poorer executions for retail traders

The words that stick out from that passage are “far from clear” and “probably”. Am I getting screwed here or not?

Here is a bit of a Barron’s interview with Gary Gensler, chair of the SEC, who says that banning for payment flow is “on the table”:

Gensler says the practice has “an inherent conflict of interest”. Market makers make a small spread on each trade, but that’s not all they get, he said.

“They get the data, they get the first look, they get to match off buyers and sellers out of that order flow,” he said. “That may not be the most efficient markets for the 2020s.”

He didn’t say whether the agency has found instances where the conflicts of interests resulted in harm to investors.

He didn’t say? It sounds like Gensler isn’t quite sure if I’m getting screwed, either. Furthermore, what he seems to be worried about is that one group of institutional traders is getting better information about order flow than another. This is the sort of thing that helps one guy with a lot of computers capture a few basis points of profit at the expense of another guy with a lot of computers. And that seems very far indeed from the question of whether little ol’ Rob Armstrong is getting played for a sucker or not.

There are also two good reasons for thinking that I and other retail traders are not being played for suckers. Retail trades are now mostly free, and bid-ask spreads are very tight. Here are average spreads on the S&P 500 over the past 10 years, as provided by Larry Tabb, head of market structure research at Bloomberg:

You can see that the Covid-linked volatility caused spreads to blow out in March last year. But what did they blow out to? Less than two-tenths of a per cent. Today we remain at an above average six-hundredth of a per cent. These are cost levels that, as a retail investor, I really truly deeply don’t care about, especially given I am not paying a trading commission. If some market maker is screwing some other market maker out of their slice of six-hundredths of 1 per cent of my trade, I say, “Screw away! This is America!” 

It is probably worth saying a little bit about the economics of payment for retail order flow here. Here is how it works, as best as I can understand it (it is explained somewhat better and at greater length here):

Some trading takes place on public exchanges, where it is visible to everyone;

Bid-ask spreads on exchanges are relatively wide. This is true in part because market makers on the exchange need to be compensated for the possibility that a series of orders from a mighty whale of an institutional trader is about to move the market against them. Say our market maker buys 100 shares of stock X for $100 each, but that big whale keeps the sell orders coming and coming, pushing the market down to $99.99, $99.98, and so on. Market makers don’t want to build up inventory; they have to sell what they buy; the falling price is bad news. So the exchange market makers put in a bit more spread, in case the whales start splashing around;

Wholesale traders, such as Citadel or Virtu, buy bunches of small orders from retail brokers such as Robinhood and trades them on a private platform, off the exchange, where they can’t be seen by everyone;

The wholesaler is required to execute the trades inside of the public bid-ask spread available on the exchange. But the wholesaler doesn’t let any whale traders into their private trading pool. They specialise in buying and matching minnow trades, so their private pool spreads can be tighter than the public exchanges’ and they can still make money. The wholesalers can also price their trades to smaller fractions of a penny than is allowed on the exchanges, which helps. They also don’t have to pay exchange fees;

So the wholesalers can afford to take some of the money they make and pay it to the broker who passed on the trades.

Now you see why Gensler mentioned the “they get the first look” stuff. Because who is really getting mistreated? The institutions that trade on the exchange, who don’t get to see what is going on with the minnows in the wholesale traders’ private pools. That does seem unfair, because minnows have good intel, as every fisherman knows.

Now, if a huge financial institution is losing out because of unfair competition, that is something someone should care about, because anti-competitive behaviour makes the economy less efficient (it also seems like the massive amounts of money spent on high-speed trading technology would be more productively spent on something other than a zero-sum fight over fractions of pennies, but that’s another issue).

But the person who should care about this is not me, the retail investor, because if I’m getting screwed, it’s only for a tiny amount of money that does not matter to me one bit.

One good read

Agree or disagree, The Economist’s leader on the illiberal left is deftly argued (on the same topic, this is worth a read too).

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