When Debt Markets Don’t Really Act as Markets

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Brokers on the floor of the Buenos Aires Stock Exchange in June. Argentina is battling hedge funds over its debt restructuring.Credit Enrique Marcarian/Reuters
In Debt
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Is the debt market really a “market”? Several recent events, each largely independent from the others, should cause us to ask this basic question.

Start with leveraged loans. In a recent bankruptcy case, traders complained that a bankruptcy court allowed a debtor to “cram down” their claims by paying below-market interest rates.

But is there any reason to think that this leveraged loan market is a “market” that provides reliable information? Indeed, a recent Bloomberg article noted that the market in question is marred by faulty, if not backward, infrastructure. The article makes the loan market seem as if a systemic crisis were waiting to happen.

Then there are the complaints that the “liquidity rules” recently enacted by financial regulators do not consider municipal debt to be all that liquid. Financial institutions complain that this will undermine the ability of municipalities to finance themselves. Maybe, but the Dodd-Frank regulatory overhaul and the Basel III bank regulation are not really intended to address issues in the municipal debt market.

And most traders regard the bulk of the municipal debt market – issued by small towns, school districts and sewer authorities – to not be very liquid anyway. Most of this debt has but a handful of trades at most each day. That too suggests it’s not really a “market,” or at least, it’s not a very efficient market.

Then there is the bond market itself, and the questions that have been raised regarding the pricing of exchange traded funds that hold those bonds. This has special salience given the scrutiny of Pimco recently.

Fundamentally, corporate bond funds often hold large positions in bonds that don’t trade in large amounts each day. A quick liquidation is probably a bad idea, which is why some officials are thinking about whether some of these asset management firms should be regulated a bit more closely. That’s the subject of another column.

But the difficulties in pricing that the firms face again suggests that maybe, just maybe, we have to be too careful about having too much faith in even these markets.

The issue gets even more complex when we talk about the market in distressed and outright defaulted debt. After all, the business of distressed debt funds is to make money on mispriced assets. Doesn’t this tell us a good deal about the markets they play in?