Wall Street bond dealers cut their holdings of corporate securities to a more than eight-year low as banks reduced risk amid the European sovereign debt crisis and concerns that the economic recovery is faltering.
The 22 primary dealers of U.S. government securities that trade directly with the Federal Reserve reduced inventories of corporate debt due in more than a year by 9.6 percent to $54.6 billion in the week ended Oct. 5, according to Fed data. Stockpiles have dropped 42 percent since May to the lowest since July 2003.
The decrease underscores the fragility of debt markets even as prices rally from the biggest losses since 2008. Evaporating liquidity crippled trading in corporate bonds and contributed to declines of 7.6 percent in August and September for junk-rated securities. It also caused a surge in a measure of the cost to buy and sell credit to a more than two-year high.
“On both sides of the ocean, banks are holding more cash and continue to de-risk,” said Alberto Gallo, senior credit strategist at Royal Bank of Scotland Group Plc in London. “The impact that all of this has on secondary trading is a prolonged dry-up in liquidity. Transaction costs have increased. Investors are trying to stick to liquid instruments, and they demand a premium to buy illiquid assets. Unfortunately we don’t see that changing between now and year-end.”
Bid Ask Spreads
The gap between where dealers buy and sell protection using credit-default swaps reached the widest since July 2009 this month. The so-called bid-ask spread for the 15 most-traded credit-default swaps on U.S. investment-grade companies expanded to 18.7 basis points on Oct. 4, compared with 4.9 basis points at the end of July, according to market prices compiled by London-based CMA. That’s equivalent to $18,700 on a $10 million contract. The spread narrowed to 13.2 basis points yesterday.
Junk bonds, graded below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s, have gained 1.3 percent this month.
The Fed data also includes holdings of mortgage securities not backed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae.
The $600 billion market for U.S. commercial-mortgage-backed securities may be the most damaged by the unwillingness of dealers to take risk, said Paul Norris, a senior money manager at Dwight Asset Management Co. in Burlington, Vermont, which manages and advises on about $54 billion of assets.
“It’s frightening how this is like 2008 again to me as far as liquidity goes,” he said in a telephone interview referring to CMBS. Dealers have pulled backed after “a lot got burned really badly” carrying inventories of the bonds or property loans that they intended to package into securities, he said.
Banks have been pulling back even before the implementation of a regulatory overhaul that seeks to increase capital requirements and ban them from trading for their own accounts.
Fixed-income trading desks could suffer a 25 percent decline in revenue under a proposal being considered by U.S. regulators that may forbid market-makers who trade debt securities for customers from amassing positions “in expectation of future price appreciation, Brad Hintz, a brokerage analyst at Sanford C. Bernstein & Co., wrote in an Oct. 10 note to investors.
The proposed so-called Volcker rule has yet to impact dealer inventories, which are declining because of cautious risk managers and the weak economy, Hintz said in an e-mail.