Old school bond market players love to talk about a boogeyman they call the “noneconomic” buyer. These buyers are large investors—central banks, insurance companies, commercial banks and even index funds—that supposedly do not care about returns, and will pay any price when transacting bonds.
The copy goes that astute economic buyers—read, active bond fund managers—profit at their foolishness. But, just like the furry creature that lived under your bed as a kid, the noneconomic bond investor does not exist. In my entire career, none of these sophisticated institutional clients has ever handed me a business card with the title “Noneconomic Buyer.”
These active players want to suggest that their participation in the bond markets is somehow better or smarter than that of the noneconomic investors. But that assumption may be off base, for two reasons.
Simple, smart and fast
First, bonds are essentially simple. There is some principal amount, at some interest rate and a maturity date. Some bonds can be a touch more complicated, with calls or amortizing balances, but the basics are the same. Bond transactions can be thought of mostly as a series of cash flows. So, market participants who buy and sell bonds at different prices are expressing different views about a number of variables: the likelihood that these cash flows will be received (credit quality); the velocity at which they may be received (prepayment or extension); their relative value to other bonds; and their interest rates relative to prevailing rates. (For example, a bond paying 4% typically fetches less when other, similarly situated bonds are paying 5%; the market is usually smart and fast enough to price that 4% bond to yield 5%.)
Different prices, different goals
Second, bond market participants buy and sell at different prices because they have distinct investment objectives, business models and time horizons.
- Active bond fund managers may aim to beat a benchmark and other bond funds in order to be attractive to retail investors. This goal makes the manager’s trading behavior more likely to be focused on paying the lowest prices with the hopes of higher returns.
- Central banks like the Federal Reserve may be engaged in quantitative easing through large-scale bond purchases. If so, they may be willing to pay higher prices for, say, current coupon mortgage bonds to help influence mortgage rates. They may not be willing to pay the same prices for more seasoned bonds with higher coupons, or for one tenor versus another. These considerations impact how the central banker thinks about price, but she is anything but noneconomic. She is intensely price focused!
- Other investors, like insurance companies, may place more emphasis on a bond’s yield and income generation capacity than its potential for capital appreciation. These investors also tend to have a much longer investment horizon and lower return hurdles than shorter-term bond fund managers or leveraged investors. Thus they may be willing to secure the same bonds at a slightly higher, but still attractive price. Again, that doesn’t mean they’re not focused on price.
- Banks may be willing to pay higher prices for more liquid, on-the-run (most recently issued) bonds as part of a liquidity management program. This isn’t noneconomic; it’s sensible in the context of the economics of a commercial bank.
- Finally, bond exchange traded funds (ETFs) and index funds are sometimes described as noneconomic actors because they must hold what’s in the index, thus making them “forced” buyers and sellers. While this is broadly true, in practice bond ETF managers make active decisions about when to transact bonds that bring their portfolio performance as close as possible to the index. If a bond cannot be traded at a price the ETF manager sees as reasonable, then the manager can hold it and wait for a better price. Their goal is always to minimize transaction costs and tracking error to the index. (It’s worth pointing out that many active bond fund managers actually use ETFs to execute investment ideas.)
These are just a few examples, among many, that influence pricing behavior by a very large group of institutional investors in the bond market. That behavior is rational, reasonable and in line with their business models, capital structures, investment programs and economic objectives.
Indeed, the bond market is largely dominated by these types of institutional investors. Federal Reserve Financial Accounts data shows that 94% of the Treasury market and 83% of the corporate bond market is made of institutional investors. Is it sensible to assert that they are all wrong? Is it logical to believe that their presence somehow reduces price efficiency and creates more opportunities to capture mispricing? I’d say no.
The bond market is heavily influenced by a multi-faceted cast of professional price setters with structural advantages. Banks enjoy a base of stable retail bank deposits for long-term funding; insurance companies are often awash in new cash to invest from premiums, making them aggressive seekers of bonds; and central banks boast vast purchasing power that comes with monetary policy operations. Recall that even major titans of bond fund management regularly differ in their views about the price impact arising out of stopping and starting quantitative easing programs. Some predict monster selloffs in government bond markets, and others assert the opposite. Someone is always wrong.
The fact is that the bond market isn’t so special or different. Indeed, some would argue it’s more efficient in pricing than other markets. But, I’d suggest there is no such thing as a “wrong price” in any market. Prices reflect different views and investment objectives. It is the diversity of these views that creates price formation—and a robust, vibrant bond market—in the first place. Looking for noneconomic buyers as the source of outperformance is like looking for the boogeyman.
Martin Small is the Head of U.S. iShares and a regular contributor to The Blog.
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