Dealers Slash Bond Holdings as Conviction in Rally Wanes: Credit Markets

Photographer: Aaron Harris/Bloomberg

Lions Gate Entertainment Corp. vice chairman Michael Burns. Close

Lions Gate Entertainment Corp. vice chairman Michael Burns.

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Photographer: Aaron Harris/Bloomberg

Lions Gate Entertainment Corp. vice chairman Michael Burns.

Wall Street’s biggest bond dealers have been cutting their holdings of corporate debt to the lowest since September, signalling limited conviction behind the credit market rally that began last month.

The 18 primary U.S. government debt dealers that trade directly with the Federal Reserve held $80.6 billion of corporate bonds with maturities greater than one year as of June 30, down 20 percent from this year’s high of $101.6 billion on Jan. 20, according to central bank data. The Fed will release primary dealer positions as of July 6 today.

The 66 percent decline in dealer holdings from a peak of $235 billion in October 2007 shows risk appetite never recovered from the credit crisis amid proposals for tighter regulation, increased capital requirements and concern the global economy may slow. The reduced holdings may expose investors to wider price swings if sentiment turns negative, according to State Street Corp.’s William Cunningham in Boston.

“Liquidity is very scarce when you need it,” said Cunningham, head of credit strategies and fixed-income research at the investment unit of State Street, which oversees almost $2 trillion. “While the markets are operating, the depth of bids and the depth of liquidity is so shallow that you cannot rely on this if conditions get worse.”

The extra yield investors demand to own corporate bonds instead of Treasuries fell 1 basis point to 188 basis points, or 1.88 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. The index has declined for five straight days, the longest stretch since March 11. It’s fallen from 201 basis points on June 11. Yields declined to 3.929 percent.

Credit-Default Swaps

Elsewhere in credit markets, the cost of protecting corporate debt from default rose in the U.S. following the Federal Reserve’s assessment that the economic outlook has “softened.” Relative yields on emerging market bonds widened after tightening for six straight days.

The cost of insuring against losses on European investment- grade corporate bonds using credit-default swaps fell to the lowest in more than two months after Spain’s successful 3 billion-euro ($3.8 billion) sale of 15-year debt.

Contracts on the Markit iTraxx Europe Index of 125 companies dropped 0.7 basis point to 113.1 as of 12:09 p.m. in London, the lowest since June 21, according to Markit Group Ltd. Credit-default swaps on Spanish government debt declined 4 basis points to 216, CMA prices show.

Maximum Amount

Today’s Spanish auction raised the maximum offered at an average yield of 5.116 percent, compared with 4.434 percent at a sale of the same securities on April 22, the Bank of Spain said. Demand was 2.57 times the amount sold, compared with a bid-to- cover ratio of 1.79 in April. The nation’s bonds rose, while the euro strengthened.

Sellers of debt insurance on about $504 million of Truvo Subsidiary Corp. debt may pay 97 cents on the euro to settle credit-default swaps that were triggered when the publisher of business directories filed for bankruptcy.

Traders set an initial recovery value of 3 percent on the Belgian company’s bonds at an auction today, according to administrators Markit Group Ltd. and Creditex Group Inc., and will set a final value later.

Credit swaps typically decline as investor confidence improves and rise as it deteriorates. They pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Emerging Markets

The extra yield investors demand to own emerging market bonds instead of government debt rose 8 basis points to 305 basis points, according to index data from JPMorgan Chase & Co. The spread, down from 339 basis points on July 1, was as low as 229 on April 15 and as high as 359 on May 25.

Toyota Motor Corp., the world’s biggest carmaker, sold $1.75 billion of bonds backed by auto loans after boosting the offering from $1.25 billion. Lions Gate Entertainment Corp., the independent film and TV producer, approached creditors of ailing Metro-Goldwyn-Mayer Inc. to help shape a plan to acquire the studio.

The $587 million top-rated portion of Toyota’s offering, maturing in about 1.85 years, yields 18 basis points more than the benchmark interest rate, according to a person familiar with the transaction who declined to be identified because terms aren’t public.

Auto Bonds

Sales of asset-backed securities tied to vehicle debt represent about $34 billion of the $55 billion in bonds linked to consumer and business lending this year, according to Bank of America Corp. data. The Charlotte, North Carolina-based lender forecasts issuance of $60 billion for bonds backed by auto debt this year.

Investec Plc plans to offer bonds backed by U.K. prime and non-conforming mortgages in the South African investment and private bank’s first public sale of the notes in Europe since March 2007.

The lender intends to issue from 175 million pounds ($267 million) to 250 million pounds of bonds, Richard Downer, Investec’s London-based head of banking and institutions group said in an interview. The transaction may be ready by year end, he said.

Bonds from Petroleos Mexicanos were the most actively traded U.S. corporate securities yesterday by dealers, with 139 trades of $1 million or more, followed by Morgan Stanley, with 114, Bloomberg data show. The Mexican state-owned oil company sold $2 billion of bonds in overseas markets July 13 after its benchmark yields fell to the lowest level in almost six months.

Ford Junk Notes

The most active in junk bonds was Ford Motor Co. with 87 trades. High-yield, high-risk debt is rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

Lions Gate Vice Chairman Michael Burns has been meeting in New York with investors who hold some of MGM’s $3.7 billion of debt, according to two people with knowledge of the situation who requested anonymity because the discussions are private.

Any agreement to buy Los Angeles-based MGM, which won another loan reprieve from creditors yesterday, would have to be approved by Carl Icahn, Lions Gate’s largest shareholder. He took a 10-day break from efforts to gain control of Vancouver- based Lions Gate’s board so the company could make a case for certain acquisitions, according to a regulatory filing. That standstill agreement expires on July 19. Debt-hobbled MGM is co- owner of the James Bond franchise.

Stricter Rules

Bank’s appetite for risk may remain in check until regulators finish implementing stricter regulations that may pass Congress this week, said William Dennehy, senior fixed- income money manager at Chicago-based Northern Trust Co., which has $150 billion in assets under management.

“Until all the regulatory uncertainty is ironed out, they’re not in a position to know how much capital they need to have on their balance sheets, how much capital support they’re going to need,” Dennehy said.

The Fed data, while an imperfect measure, “is a leading indicator of dealer risk appetite, liquidity and volatility,” said J.J. McKoan, co-director of global credit investments in New York at AllianceBernstein LP, where he helps manage $199 billion in fixed-income assets.

Bank risk-taking may have increased in recent days as investor appetite returns, trading data suggests. The 10-day moving average of daily bond trades climbed to $14.6 billion on July 13, up from a six-month low of $13.6 billion on July 9, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“Liquidity comes and goes with risk appetite,” said Thanos Bardas, a managing director at Chicago-based Neuberger Berman LLC, which manages about $80 billion in fixed-income assets. “There’s more liquidity when spreads are narrowing and less when spreads are widening.”

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; John Detrixhe in New York at jdetrixhe1@bloomberg.net

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