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Liquidity Myth Seen by JPMorgan as Trading Gains: Credit Markets

Rising corporate-bond trading signals that liquidity is robust even as Wall Street’s biggest banks cut their inventories of the securities in response to new rules and regulations, according to JPMorgan Chase & Co.

Average daily trading volumes in U.S. investment-grade corporate bonds has increased 18 percent since the end of April from the same period last year, while dealers pared holdings of the debt by 54 percent in the five weeks ended July 3, data from the Financial Industry Regulatory Authority and the Federal Reserve show. The so-called bid-ask spread that dealers charge in bond trades grew 3 basis points in the period, less than half the increase in 2011 amid Europe’s fiscal crisis.

Almost five years after the collapse of Lehman Brothers Holdings Inc., credit markets are becoming better oiled to withstand stress, JPMorgan analysts led by Nikolaos Panigirtzoglou wrote in a July 12 note. Rather than driving liquidity by taking big positions, banks are simply acting as the go-between for buyers and sellers, while the number of market makers increases and electronic systems emerge to facilitate trading, they said.

Market Buffers

“The only way for the market to work when dealers can’t act as a buffer is if you’re able to match a seller from a mutual fund with a buyer from an institutional investor, and so far that has worked,” Bank of America Corp. credit strategist Hans Mikkelsen said in a telephone interview. “Back in the old days, dealers were able to act as buffers in the market: they would accumulate bonds on their balance sheets, and that’s not happening anymore.”

Dollar-denominated, investment-grade bonds lost 5 percent in the two months ended June, the biggest declines since the 2008 financial crisis, as concern mounted that the Fed was preparing to scale back stimulus measures that have bolstered debt prices, Bank of America Merrill Lynch index data show.

“The recent volatility episode has not significantly affected either trading volumes or the bid-ask spreads of the largest U.S. high-grade corporate bonds,” the JPMorgan analysts wrote. “Broker-dealers have become a lot more efficient and can sustain a high volume of trading with a smaller inventory.”

Record Offerings

Investors snapping up a record pace of new corporate-bond sales may have muted trading of existing debt earlier this year, Alexander Sedgwick, head of research at MarketAxess Holdings Inc., said in a telephone interview. “With low volatility, there hasn’t been as much of an impetus up until the last couple weeks to move any money around,” he said.

A MarketAxess index that tracks the bid-ask spreads, or the difference between where bonds are bought and sold, for the 1,000 largest and most actively traded issues widened to 10.5 basis points on July 15 from 7.5 on April 29, according to the data from the electronic bond-trading platform owner. Over a five-month period ended Sept. 19, 2011, as markets were being roiled by concern a Greece default would jeopardize Europe’s common currency, the spread widened to 15.6 from 8.5, the data show.

“Since the crisis, we’ve generally run portfolios with higher levels of liquidity, knowing that the markets were going to be more volatile and we want to be able to be nimble,” said Ashish Shah, the head of global credit at AllianceBernstein Holding LP, which oversees $257 billion in fixed-income assets. “That lesson still holds. You can’t give up that liquidity.”

Credit Benchmarks

Elsewhere in credit markets, the cost to protect against corporate-bond losses in the U.S. fell to a seven-week low after Fed Chairman Ben S. Bernanke said central bank plans to curtail stimulus could be delayed if the economy weakens. Honda Motor Co. sold $1.5 billion of bonds backed by auto loans after increasing the offering’s size by $500 million. Harbor Freight Tools USA Inc. set the rate it will pay on a $1 billion covenant-light term loan it’s seeking to refinance debt and support a dividend.

Bonds of Goldman Sachs Group Inc. were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 4 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The fifth-biggest U.S. bank by assets sold $2.5 billion of 2.9 percent, five-year notes on July 16, Bloomberg data show. The securities rose 0.2 cent from the issue price to 100.1 cents on the dollar to yield 2.87 percent, according to Trace.

Rate Swaps

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.4 basis point to 17.45 basis points. The gauge typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, declined 2.1 basis points to a mid-price of 75.9 basis points, the lowest since May 28, according to prices compiled by Bloomberg.

The Fed’s $85 billion of monthly asset purchases that have been bolstering credit markets aren’t on a “preset course,” Bernanke said yesterday.

“We’re going to be responding to the data,” the Fed chairman said in testimony before the House Financial Services Committee. “If the data are stronger than we expect, we’ll move more quickly” to reduce purchases, he said. If data “don’t meet the kinds of expectations we have about where the economy’s going, then we would delay that process or potentially increase purchases for a time.”

Honda Offering

The Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, dropped 1.1 to 104.2 at 9:59 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan slid 4 to 133.

The credit-swaps indexes typically fall as investor confidence improves and rise as it deteriorates. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

A top-ranked $458 million portion of Honda’s offering maturing in 2.1 years yields 27 basis points more than the benchmark swap rate, Bloomberg data show.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index rose for an eighth day, climbing 0.07 cent to 98.18 cents on the dollar. That’s the longest stretch of increases for the measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, since it rose for 17 days ended May 13.

Harbor Freight

Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.

Harbor Freight, the tool and equipment retailer, is proposing to pay interest at 4 percentage points more than the London interbank offered rate, with a 1 percent minimum on the lending benchmark, according to a person with knowledge of the transaction who asked not to be identified because terms are private.

In emerging markets, relative yields narrowed 6 basis points to 336 basis points, or 3.36 percentage points, according to JPMorgan’s EMBI Global index. The gauge has fallen from a one-year high of 395.3 on June 24.

Primary dealers cut their holdings of securities including corporate bonds, commercial paper, and mortgage-backed debt by 76 percent to $56 billion at the end of March from a peak of $235 billion in October 2007, New York Fed data show. The banks pared positions in investment-grade corporate bonds to $6.3 billion as of July 3, from $13.5 billion on May 29, according to data the Fed started releasing in a reformatted version in April.

Paring Positions

The banks pared the holdings as the 2010 Dodd-Frank Act in the U.S. seeks to limit the risks lenders take with their own money and the 27-country Basel Committee on Banking Supervision raises minimum capital standards. The Fed figures overstate how much banks were keeping in inventories to facilitate trading, according to the JPMorgan analysts, who attributed most of the decline to proprietary trading desks scaling back or closing to comply with the new rules.

Broker-dealers are now focused on trading on behalf of clients, rather than taking positions wagering on the direction of the market, JPMorgan’s Panigirtzoglou said. While the total number of dealers has declined since the crisis, new market participants from electronic trading platforms to non-bank trading firms have balanced the pool, he said.

Electronic Trading

“It is not only traditional broker-dealers who provide inventory for market making, but other non-traditional players are now providing their own inventory,” Panigirtzoglou said in an e-mail.

Investors are turning to electronic platforms to “access more fragmented liquidity” and reach more trading partners, Richard Prager, BlackRock Inc.’s head of trading and liquidity strategies, said in a telephone interview.

BlackRock, the world’s largest money manager, teamed with MarketAxess to create a unified bond-trading platform, routing trades on their Aladdin Trading Network through MarketAxess. About 12 percent of high-grade corporate bonds tracked by Trace were traded on MarketAxess in the first quarter, up from less than 6 percent in the same period of 2009, the company said.

“An investor’s expectation of what they can move has changed,” Prager said. “You have to work harder now to get trades done; and the bigger amounts, you have to be more patient because the liquidity isn’t there.”

New Paradigm

The market rout last month was fueled largely by sales of the easiest-to-trade securities as investors hewed to what Prager calls the “new liquidity paradigm.”

“You buy something because you think it’s really very liquid, and you actually end up suffering in a selloff because investors end up selling what they can,” said Bank of America’s Mikkelsen. “If interest rates rise too rapidly again, you don’t want to hold the most liquid stuff because that’s what gets liquidated.”

Bank bonds, the most liquid corporate debt, were sold first by investors, exacerbating losses in that corner of the market, Mikkelsen said.

The average extra yield investors demand to hold bank bonds rather than similar-maturity government securities widened as much as 48 basis points to 187 basis points on June 24 from a more than five-year low on May 22, according to Bank of America Merrill Lynch’s U.S. Banking Corporate index. That compares with a 31 basis-point increase to as high as 172 for the average high-grade corporate bond, the Bank of America Merrill Lynch U.S. Corporate Index shows.

“It was reassuring to see the amount of liquidity that was actually available,” largely offered by institutional money managers, said AllianceBernstein’s Shah. “You’re getting paid to provide liquidity as an investor in the same way that dealers used to be paid to provide liquidity, just to put up their own capital.”

To contact the reporter on this story: Mary Childs in New York at mchilds5@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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