July 23 (Bloomberg) -- Credit market trading is drying up, posing a threat to the stability of the financial system that regulators are ignoring, according to strategists at Royal Bank of Scotland Group Plc in London.
Liquidity has declined by about 70 percent since the financial crisis, a proprietary model used by the bank shows, and it’s still falling, the strategists said.
Trading is dropping away as dealers find it more expensive to hold bonds because of tighter risk limits and higher capital requirements imposed by regulators, according to RBS. That’s combining with low central bank interest rates to reduce risk premiums and making bond markets more vulnerable to shocks.
“We fear that systemic risk is being left unchecked in financial markets,” the strategists led by Alberto Gallo, head of European macro credit research at RBS in London, wrote in a note. “What happens if policy changes and investors head for the exits? Low liquidity means the door is getting smaller.”
In credit, the RBS model gauges daily trading as a percentage of bonds outstanding, dealer inventories and the gap between what it costs to buy and sell a U.S. high-yield bond as a percentage of the premium over government debt investors receive for holding the note.
Investors are receiving a “historically low” premium for the risk that they’ll be unable to exit a trade, according to the RBS, which estimates it’s halved in Europe in the past year to less than 80 basis points.
Money managers should stay away from bonds in which individuals, mutual funds and exchange traded funds are the main investors, the strategists said. That’s because the selloff last year, when the Federal Reserve indicated it would withdraw its stimulus, was greatest in those parts of the market.
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