Dealers Cut Bonds as Conviction in Rally Wanes: Credit Markets

Carl Icahn is Lions Gate’s largest shareholder
Lions Gate Entertainment Corp. vice chairman Michael Burns. Photographer: Aaron Harris/Bloomberg

Wall Street’s biggest bond dealers have been cutting their holdings of corporate debt to the lowest since September, signaling 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.”

Credit-Default Swaps

Elsewhere in credit markets, 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.

The cost of protecting corporate debt from default rose in the U.S. and Europe. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or speculate on creditworthiness, climbed 0.90 basis point to a mid-price of 109.77 basis points as of 11:51 a.m. in New York, according to Markit Group Ltd. In London, the Markit iTraxx Europe Index of swaps on 125 companies with investment-grade ratings increased 2.01 to 115.87.

Both indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps 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.

JPMorgan Offering

JPMorgan Chase & Co., the second-biggest U.S. bank by assets, plans to sell 10-year global notes as soon as today after reporting profit rose 76 percent, more than analysts estimated.

The sale will be benchmark in size, according to a person familiar with the transaction, who declined to be identified because terms aren’t set. A benchmark sale is typically at least $500 million.

JPMorgan, based in New York, is marketing debt after it said second-quarter net income climbed to $4.8 billion, or $1.09 a share, from $2.72 billion, or 28 cents, in the same period a year earlier. The per-share earnings compared with an average estimate for adjusted earnings of 71 cents projected by 22 analysts surveyed by Bloomberg.

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.

‘Regulatory Uncertainty’

“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.”