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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,” said the analysts at JPMorgan, the biggest underwriter of corporate bonds. “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. dropped to the lowest in eight weeks. Bank of America Corp., the second-biggest U.S. lender, plans to sell $2 billion of 10-year bonds.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, declined 2.3 basis points to a mid-price of 74 basis points as of 12:03 p.m. in New York, the lowest since May 23, according to prices compiled by Bloomberg.

In London, the Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, dropped 3.5 to 101.8.

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.

BofA Offering

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, declined 0.3 basis point to 17.15 basis points. The gauge typically narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Proceeds from Bank of America’s offering will be used for general corporate purposes, according to a person with knowledge of the transaction. The securities, which may be rated Baa2 by Moody’s Investors Service, may yield 157 basis points more than similar-maturity Treasuries, the person said.

Chief Executive Officer Brian T. Moynihan’s cost-cutting efforts helped the bank boost net income by 63 percent to $4.01 billion in the second quarter, exceeding analyst estimates, the Charlotte, North Carolina-based lender said yesterday in a statement.

Bonds of New York-based Morgan Stanley are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 2.8 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.

Paring Positions

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.

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.

Electronic Trading

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.

“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 14 percent of high-grade corporate bond trades tracked by Trace were executed on MarketAxess in the second quarter, up from less than 5 percent in the same period of 2009, the company said.

‘More Patient’

“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.”

During the market rout last month, investors yanked a record $26 billion from high-grade mutual funds and exchange-traded funds, Bank of America analysts Mikkelsen and Yuriy Shchuchinov said in a July 16 note to clients. The withdrawals accelerated a surge in U.S. corporate-bond yields that started in May, pushing them to a 15-month high of 3.58 percent on July 5 from a record-low 2.65 percent on May 2, Bank of America Merrill Lynch index data show.

“Insurance companies and pension funds, who are often in a better position to take advantage of the higher all-in yields, had not yet come in as buyers, given the volatility,” said Christopher Lemmo, a trader in Stamford, Connecticut at BlueBay Asset Management LLP, a fixed-income manager owned by Royal Bank of Canada that oversees more than $53.9 billion. “With few buyers about, dealers were unable to move risk, which subsequently led to poor liquidity and wider spreads.”

New Paradigm

The decline largely was fueled 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.”

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