Wall Street Haunted by ‘08 Loses Risk Appetite: Credit Markets

Wall Street Haunted by '08 Loses Risk Appetite
Traders work on the floor of the New York Stock Exchange. The difference between where dealers will buy and sell the 15 most-traded credit-default swaps on U.S. investment-grade companies has widened to 14 basis points from 4.6 basis points at the start of August, according to market prices compiled by CMA. Photographer: Jin Lee/Bloomberg

Aug. 29 (Bloomberg) -- Wall Street traders are demanding the biggest premiums to buy and sell credit in almost two years as they seek protections from market swings driven by Europe’s debt crisis and a slowing global economy.

A measure of the cost of trading credit-default swaps has tripled this month as prices gyrate the most in 13 months, according to data compiled by Bloomberg and CMA in London. Amid the volatility, the biggest bond dealers cut their holdings of corporate securities to $73.1 billion as of Aug. 17, the least since July 2009, Federal Reserve data show.

The surge underscores the fragility of credit markets three years after the collapse of Lehman Brothers Holdings Inc. triggered the biggest corporate bond losses in at least 35 years. With junk-rated securities poised to lose the most this month since November 2008, banks and investors are bracing for broader declines on concern Europe’s fiscal imbalances will infect the banking system at a time when the economy may not be strong enough to withstand such headwinds.

“The specter of 2008 still looms large,” said Tom Farina, a managing director at Deutsche Insurance Asset Management, which oversees $200 billion. “People understand that tail risk is still quite large in comparison to the way we used to think about it,” he said, referring to extreme market moves that fall outside probable outcomes forecast by Wall Street.

Bid-Ask Spread

The difference between where dealers will buy and sell the 15 most-traded credit-default swaps on U.S. investment-grade companies has widened to 14 basis points from 4.6 basis points at the start of August, according to market prices compiled by CMA. That’s equivalent to $14,000 on a $10 million contract and up from $4,600. The so-called bid-ask spread has increased to 5.4 percent of the annual cost of the contracts, the most since December 2009 and up from 3 percent on Aug. 1.

“The dealer community is not putting risk on,” said Jason Rosiak, the head of portfolio management at Newport Beach, California-based Pacific Asset Management, an affiliate of Pacific Life Insurance Co. “They’re not cushioning the blow as they once upon a time were, and this leads to more volatility.”

Elsewhere in credit markets, the cost to protect U.S. company debt from default fell to the lowest level in more than a week. The extra yield investors demand to hold the top-ranked portion of bonds backed by commercial mortgages jumped to the highest level since June 2010, and leveraged loan prices plunged to the lowest since 2009.

Absolute Yields

Relative yields on company bonds from the U.S. to Europe and Asia expanded 11 basis points last week to 231 basis points, or 2.31 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. The spread has expanded from 170 at the end of July and is at the widest since Aug. 21, 2009.

Absolute yields increased to 3.82 percent from 3.67 percent on Aug. 19. The Barclays Capital Global Aggregate Corporate Index has lost 0.98 percent this month, paring the gain for the year to 6.3 percent.

The cost to protect corporate debentures from losses in the U.S. pared five straight weeks of gains. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on company debt or to speculate on creditworthiness, dropped 4.3 basis points to a mid-price of 122 basis points as of 9:17 a.m. in New York, according to Markit Group Ltd. The benchmark has risen this month from 96.3.

The index typically increases as investor confidence deteriorates and falls as it improves. The contracts 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 swap protecting $10 million of debt.

Super Duper Index

Spreads on the BarCap CMBS AAA Super Duper Index widened 11 basis points last week to 303 basis points, or 3.03 percentage points. Relative yields have climbed from 2.13 percentage points since July 25.

Investors are demanding higher spreads as Wall Street banks plan to sell as much as $5 billion of bonds tied to commercial mortgages in September and October as they offload loans agreed to before the deterioration in credit markets, Julia Tcherkassova, a commercial-mortgage debt analyst at Barclays Capital in New York, said last week.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index fell 1.12 cents last week to 87.47 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, is down from this year’s high of 96.48 on Feb. 14. The index has lost 6.6 percent this month, the most since November 2008. Loans have declined 4.7 percent in 2011.

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

Typically Volatile

August can typically be volatile because many traders and investors are away from the office, New York-based Farina said. “You have a lot of senior investors not engaged in the markets,” he said.

That’s been exacerbated by investors pulling back from the riskiest debt after S&P stripped the U.S. government of its AAA rating, yields on Spanish and Italian debt climbed to euro-era records and the Fed said Aug. 9 that the recovery in the U.S. has been “considerably slower” than anticipated.

Fed Chairman Ben S. Bernanke said last week the central bank has tools to stimulate a recovery, though he didn’t give details on the measures the Fed might take or signal when or whether policy makers might deploy them. Earlier this month the Fed pledged for the first time to keep its benchmark interest rate at a record low at least through mid-2013.

Price Swings

A measure of price swings over a 30-day period for the Markit CDX investment-grade index jumped to 56.6 last week from 31.1 on Aug 1., data compiled by Bloomberg and Markit Group Ltd. show. That’s the widest since July 2010.

The gap between how much bond dealers are willing to pay for distressed debt and how much they’ll sell it for widened to levels that made investors reluctant to trade, said Stefan Lingmerth, an analyst for Phoenix Investment Adviser LLC in New York. The bid-ask spread on the riskiest bonds expanded to 5 or 10 percentage points from 2 percentage points, he said.

“Liquidity just dried up,” Lingmerth said in a telephone interview. “There’s no market.”

Junk bonds have lost 5.1 percent this month, the worst performance since a decline of 8.4 percent in November 2008, Bank of America Merrill Lynch index data show. Distressed bonds have declined 12.5 percent since July.

Some banks pulled back from risk-taking in capital markets during the second quarter as U.S. corporate bond spreads reached their tightest levels since October 2007.

Value-At-Risk

Goldman Sachs Group Inc. cut its value-at-risk, or VaR, the maximum amount the company estimates it could lose from trading on 95 percent of days, to $101 million. The figure was the lowest since the third quarter of 2006. David Wells, a spokesman for Goldman Sachs in New York, declined to comment.

“I’m sure that the big banks are under increasing pressure to keep the VaR figure at a very manageable level,” Adrian Miller, fixed-income strategist at Miller Tabak Roberts Securities LLC in New York, said in an interview.

Corporate debt held by the 18 primary U.S. government debt dealers that trade directly with the Fed has dropped 23 percent from $94.9 billion on May 25, Fed data show.

Even as credit markets rallied over the past two years and investors snapped up $3.2 trillion of U.S. investment-grade and high-yield, high-risk bonds since 2008, banks never regained risk appetites close to the levels of the years before the crisis, the dealer holdings data show.

Dealer Holdings

Primary dealer holdings of corporate securities peaked at $235 billion in October 2007. They dropped to as low as $59.8 billion in April 2009, though the highest they reached since is $101.6 billion in January 2010.

The average bid-ask spread on the most-traded credit swaps reached a record wide of 52 basis points in October 2008, the month after Lehman Brothers filed for bankruptcy protection. They fell to as low as 3.9 basis points in May. From 2005 to July 2007, the average was 2.9 basis points.

The average annual cost to protect debt using the contracts soared to a two-year high of 264.6 basis points on Aug. 24, from 152.9 on Aug. 1. The average was 259 basis points on Aug. 26.

“Banks over the last few years have contributed a smaller portion of their balance sheet towards providing liquidity to buy-side firms, folks like myself,” said David Brown, a money manager in Chicago at Neuberger Berman Management LLC, which oversees $85 billion of fixed-income assets. “Wall Street could act somewhat as a shock absorber to some of these spread movements when they were able to use their own balance sheet to provide liquidity, and they do that much less now.”

Market Conditions

The extra yield investors demand to own U.S. investment-grade corporate bonds instead of Treasuries climbed to 227 basis points on Aug. 26, the highest since October 2009, according to Bank of America Merrill Lynch’s U.S. Corporate Master index. Spreads have widened from 145 basis points on April 11.

Even as investors return from summer holidays in the U.S. next month, market conditions may not improve soon, said Bill Bemis, a senior fixed-income money manager who helps oversee about $57 billion of such assets at Aviva Investors in Des Moines, Iowa.

It’s “likely here to stay until we get some resolution on these longer-term issues, some resolution on what’s going to happen in Europe, and ultimately, are we from an economic standpoint in the U.S. heading into another recession or continuing at this very slow growth rate we’ve seen this year,” Bemis said. “You’re not going to get a resolution overseas near-term so our expectation would be you would see this volatility and uncertainty around for the next three to six months.”

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

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