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Bond Dealer Retreat Seen in Trades Shrinking 39%: Credit Markets

BlackRock CEO Laurence D. Fink
Laurence "Larry" D. Fink, chairman, chief executive officer and co-founder of BlackRock Inc., said last month that the Federal Reserve’s policy is contributing to “bubble-like markets.” Photographer: Lam Yik Fei/Bloomberg

Nov. 19 (Bloomberg) -- Corporate-bond trades have shrunk to the smallest in a year, exchanging hands in chunks that have contracted 39 percent from before the credit crisis in another sign of a dealer pullback that threatens to drive up borrowing costs.

The average investment-grade bond transaction declined 9.4 percent to $501,635 in the three months ended Sept. 30 from $553,410 in the first quarter, according to Financial Industry Regulatory Authority data. Trade sizes have contracted from $815,828 in 2007, even as the total amount of corporate-debt outstanding swelled 92 percent during the same period.

The smaller transactions illustrate conditions that money managers including BlackRock Inc.’s Laurence D. Fink say have driven up costs for clients and made it more difficult to buy and sell debt. That may accelerate a surge in borrowing costs and exacerbate investor losses if a Federal Reserve pullback from unprecedented stimulus efforts triggers a cash exodus.

“When the market turns, if there are no counterparties to step in, the lack of liquidity could push prices down pretty quickly,” Brian Rehling, chief fixed-income strategist at Wells Fargo Advisors in St. Louis, said in a telephone interview. “Back in May and June, when interest rates increased, you definitely saw some of the illiquidity push prices down.”

Dealer Pullback

Five years after the financial crisis that pushed Lehman Brothers Holdings Inc. into bankruptcy, new regulations are deterring Wall Street banks from buying larger chunks of corporate debt to sell at a profit, fueling a 76 percent decline in a Fed measure of dealer holdings of the debt.

Even after the dollar-denominated corporate-bond market almost doubled to $4.3 trillion the past six years, trading has failed to keep pace, increasing 48 percent during the same period. Both large and small investors have been affected by the shrinking trade sizes, with transactions bigger than $5 million falling 13 percent to an average $11.3 million this year from $13 million in 2007, according to a Nov. 15 report from Barclays Plc strategists led by Jeffrey Meli and Bradley Rogoff.

“Even if dealers had the ability to take inventory on their balance sheet, there wouldn’t necessarily be the conviction to do that,” Rogoff, head of global credit strategy in New York, said in a telephone interview. With the swings of cash in and out of mutual funds getting bigger, he said, “investors seem to be going in the same directions all at once.”

Investor Withdrawals

After pouring $1.26 trillion into bond funds the previous six years, investors yanked a record $61.7 billion from them in June amid mounting speculation that the Fed was poised to start tapering $85 billion in monthly bond purchases, data from TrimTabs Investment Research show.

Investors pulled $13.6 billion from U.S. corporate-bond funds the same month, according to data compiled by Royal Bank of Scotland Group Plc. Dollar-denominated, investment-grade debt lost 2.76 percent in June after declining 2.3 percent in May, according to Bank of America Merrill Lynch index data.

During the four months since June, the funds reported $24.4 billion of deposits as the Fed maintained the pace of its purchases, RBS data show.

BlackRock’s Fink, whose company is the world’s largest money manager with $4.1 trillion in assets, said last month that the Fed’s policy is contributing to “bubble-like markets.”

The New York-based firm last year said it planned to start a bond-trading system to allow investors to bypass investment banks to lower transaction costs.

‘Better Exchanges’

“We’re going to need a vehicle in which there are better exchanges of buyers and sellers,” Fink said in a July 10 Bloomberg Television interview. With dealers cutting inventories in response to risk-curbing rules, he said, “that’s why we’re experiencing at this moment some stress in the markets of buying and selling bonds, especially corporate bonds.”

Average trade sizes in investment-grade bonds in the U.S. are the lowest since they reached $472,055 in the three months ended Sept. 30, 2012, according to Trace, Finra’s bond-price reporting system.

While the amount of dollar-denominated investment-grade notes has soared from $2.2 billion at the end of 2007, the average daily trading volume has climbed more slowly, to $12.79 billion this year from $8.61 billion six years ago, Trace data show.

Dealer Inventories

“Average overall trade sizes have been steadily declining” since the second quarter of 2009, the Barclays analysts said in the Nov. 15 report. While the growth of exchange-traded funds and electronic platforms may mitigate the effects by providing newer trading outlets, “we do not believe that e-trading flows are yet robust enough to provide much liquidity in a volatile environment,” the analysts wrote.

Primary dealers that trade directly with the Fed reduced their corporate-debt inventories from $235 billion in October 2007 to $56 billion as of March 27, when the central bank revamped the way it calculates and reports the data. Banks globally have cut more than 500,000 jobs in the past five years and lowered riskier holdings as they comply with rules from the Basel Committee on Banking Supervision and the U.S. Dodd-Frank Act.

“What’s driving a lot of the big trends in this area is the changing cost of dealers holding inventory; the cost has gone up a lot,” Oliver Randall, assistant professor of finance at Emory University, said in a telephone interview. “Dealers are not willing to do the size of trades they were before.”

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose for a second day, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increasing 0.5 basis point to a mid-price of 71.9 basis points as of 11:04 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically rises as investor confidence deteriorates and falls 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.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.13 basis point to 10.88 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Bonds of T-Mobile US Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 6.1 percent of the volume of dealer trades of $1 million or more, Trace data show. The fourth-biggest wireless carrier raised $2 billion yesterday in a two-part offering.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

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

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