Bond Dealers Enfeebled as Liquidity Woes Boost Derivatives

Updated on

As Wall Street retreats from its traditional role as the bond market’s middle man, investors frustrated by sudden gyrations and a lack of liquidity are turning to derivatives -- in a big way.

In the world’s biggest debt markets, including the U.S., Europe and Japan, the number of futures contracts on government debt reached a post-crisis high in May after doubling since

2009. Trading of German bund options and Italian futures hit records.

While some are using derivatives to hedge against higher U.S. interest rates, Pioneer Investment Management and BlackRock Inc. are also shifting into more obscure corners of the fixed-income world as rules to limit bank risk-taking make it harder to trade at a moment’s notice. Since October 2013, dealers that trade with the Fed have slashed U.S. debt inventories by 84 percent.

“Liquidity risk is a big challenge,” said Cosimo Marasciulo, the Dublin-based head of government bonds at Pioneer, which oversees $242 billion. “And it’s now affecting an asset that was once considered most liquid -- government bonds.”

Derivatives, contracts based on underlying assets that can provide the same exposure without tying up as much capital, have become a popular option after central banks started to purchase bonds as a way to boost growth following the financial crisis, which has sapped supply and increased volatility.

Over that time, bond buying by major central banks has inundated economies with at least $10 trillion of cheap cash, according to Deutsche Bank AG.

Open Interest

Pioneer’s Marasciulo said his team stepped up its use of derivatives as the European Central Bank said in January it would buy sovereign bonds as part of its quantitative easing.

Rather than buying euro bonds tied to inflation, which Marasciulo said were too illiquid, his team entered into five-and 10-year inflation swap contracts.

In the futures market, combined open interest on 10-year Treasuries, U.K. gilts, and Japanese bonds, as well as German and Italian securities, eclipsed 5 million contracts in May, exchange data compiled by Bloomberg show. Most of the jump occurred in the past two years.

In the U.S., open interest on 10-year note futures has almost doubled in the past three years, while trading in bund options on Deutsche Boerse AG’s Eurex surged to a record 6.4 million contracts as of May 26. That’s twice as much as in May 2012, during the height of the euro debt crisis.

Bond Cutbacks

The average trading volume in benchmark Italian bond futures rose to 100,000 contracts a day this year, compared with 61,824 contracts last year and 5,060 contracts five years ago.

“The advantage is there’s tremendous liquidity and you know what your price is,” said Arthur Bass, New York-based derivatives trader at Coex Partners, referring to futures.

The shift into derivatives has accelerated as the world’s biggest banks scale back their bond-trading businesses to comply with higher capital requirements imposed by Basel III, which went into effect this year.

For Treasuries, the share of transactions by primary dealers has dwindled by more than half to 4 percent since the end of 2008, according to the Institute of International Finance, a lobbying group for banks.

And in the past year, JPMorgan Chase & Co., Morgan Stanley, Credit Suisse Group AG and Royal Bank of Scotland Group Plc have either cut back their fixed-income trading desks or are weighing reductions in those businesses.

Price Swings

That’s made getting the bonds you want at the price you need more difficult, especially when markets are moving.

Average daily trading in Treasuries among primary dealers has been lower this year than in each of the previous five years, while volume in Germany, the euro-region’s deepest debt market, has decreased almost 25 percent in the past decade.

Less trading has meant more volatility. This year, price swings for Treasuries are up almost 75 percent from their lows in 2013, data compiled by Bank of America Corp. show. The bank’s MOVE Index of volatility in the world’s largest bond market was at 82.7 on May 29, up from 75.3 at the end of April and compared with an average of 77.6 over the past five years.

“We’ve been splitting the trades into smaller pieces,” said Thanos Bardas, a Chicago-based money manager at Neuberger Berman, which oversees $104 billion of fixed-income assets. Since the crisis, Bardas said the firm has used more futures when swings in the bond market have increased.

Liquidity Meme

It’s even gotten the attention of officials at the Federal Reserve. In the minutes from its April meeting released last month, they said “the tendency for bond prices to exhibit volatility may be greater than it had been in the past.”

Jim Bianco, president of Bianco Research LLC, doesn’t buy the notion that investors are turning to derivatives because the bond market is broken.

While regulations have played a role in curtailing volume, the real reason so many investors have embraced derivatives is because everyone is trying to shield themselves before the Fed starts lifting borrowing costs.

Declining liquidity “is overplayed,” he said from Chicago. “Even if we say here’s more freedom for the dealers to make markets, we would still have people at extreme positions waiting for the Fed to raise rates.”

Whatever the reason, bond investors are increasingly looking to alternatives. At U.S. government debt auctions this year, investors bought 65 percent of Treasuries sold, the highest share on record, Treasury data compiled by Bloomberg show. Investor bidding at German auctions has also increased.

BlackRock, the world’s biggest asset manager, is taking advantage of exchange-traded funds as a way to quickly establish its positions in fixed income, according to Stephen Cohen, the New York-based firm’s chief investment strategist for international fixed income.

And it’s part of a wider trend that will only grow as trading in the bond market gets more difficult.

“This is not just BlackRock,” he said.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE