The $3 Trillion Bond Trade Citigroup Says Investors Should Fear

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Citigroup Strategist Warns of Crowded Trades

For all the concern that Wall Street’s shrinking balance sheets will fuel a liquidity crisis when investors flee credit markets, Citigroup Inc. strategist Stephen Antczak says investors may be overlooking an even bigger catalyst.

The size of the U.S. corporate-bond market has ballooned by $3.7 trillion during the past decade, yet almost all of that growth is concentrated in the hands of three types of buyers: mutual funds, foreign investors and insurance companies, according to Citigroup. That combination could lead to more selling than the market can absorb when the Federal Reserve raises interest rates for the first time since 2006, Antczak said.

“All the money is going to the same place, and when something adversely impacts one, chances are the same factor adversely impacts everyone else, and there’s nobody there to take the other side,” Antczak said in a telephone interview. “We used to have 23 types of investors in the market. Now we have three. In my mind, that’s the key driver.”

The three investor groups hold almost two-thirds of total corporate debt, Citigroup data show. Mutual funds, which are forced to sell when investors redeem cash, grew the fastest, more than doubling their share to 22 percent in 10 years. Overseas investors now hold almost a quarter of the market. Wells Fargo & Co. analysts warned last month that those buyers may be prompted to exit if the dollar weakened at the same time bond yields rose.

Liquidity Warnings

Hedge funds, government pension funds and securities brokers are among 20 other groups that hold 37 percent.

Everyone from Fed Chair Janet Yellen to JPMorgan Chase & Co.’s Jamie Dimon have echoed warnings that evaporating liquidity in the bond market will exaggerate a selloff when the central bank raises its benchmark interest rate. Most of that concern has been focused on the bond holdings of banks such as JPMorgan, Deutsche Bank AG, and Goldman Sachs Group Inc. that act as market makers and can step in to buy when investors sell.

Dealer inventories of corporate bonds plunged more than 76 percent in the years after the financial crisis as tougher banking regulations made it more expensive for them to hold risky assets.

‘Known Unknown’

“The low levels of dealer balance sheets suggest that dealers will not be willing to make purchases to offset the selling flows,” Jim Caron, a money manager at Morgan Stanley Investment Management, which oversees $406 billion, said in an e-mail. He called liquidity a “known unknown risk” for bond markets.

Citigroup’s Antczak has been telling investors that instead of focusing on the dealers, they need to diversify their positions by buying less liquid assets that other investors won’t be rushing to sell first when sentiment sours. That would help them weather volatility and potentially become buyers while others are selling.

“A couple of investors have been acting like brokers, thinking about being a source of liquidity to the Street,” Antczak said. “They are big and able to hold less-liquid positions because they don’t have to mark it against the market and can hold until maturity.”

Stepping In

That’s what New York Life Insurance Co.’s investment arm, which oversees $215 billion of policyholder money, did during the so-called taper tantrum of 2013. The Fed’s move to end its unprecedented stimulus measures that year triggered a selloff that wiped out 5 percent from U.S. speculative-grade corporate bonds in less than two months.

The declines were “exaggerated because the need for liquidity was in excess of what the dealer community could provide,” Tom Girard, head of fixed-income investments at NYL Investors, said in a telephone interview. The firm stepped in to buy both investment-grade and speculative-grade securities, he said.

“New York Life acquired significant amounts of bonds at very attractive spreads and yield levels because we were able to provide liquidity,” he said. “If we get another situation similar to that taper tantrum, then from my perspective it starts to shift from a challenge to an opportunity.”

Companies have issued an unprecedented $9.3 trillion of bonds since the start of 2009 as the Fed cut its target rate to almost zero and borrowing costs plunged to record lows, data compiled by Bloomberg show. Yields on investment grade corporate bonds in the U.S., which reached a record low 2.65 percent in May 2013, climbed to a 17-month high of 3.36 percent yesterday, Bank of America Merrill Lynch index data show.

Next Crisis

The world’s biggest money managers, including Pacific Investment Management Co., BlackRock Inc. and Vanguard Group Inc., have been discussing the issue as part of a Securities Industry & Financial Markets Association group. Last month, they asked the U.S. Securities and Exchange Commission to form an advisory committee to focus on liquidity -- the ability to buy and sell easily without greatly affecting the price of a security.

“The size of that corporate bond market, with the lack of liquidity that currently exists today, is something that people on the buy side, sell side and regulatory side need to be focused on,” James E. Staley, a managing partner at the $21 billion investment firm BlueMountain Capital Management, said last week at a conference in New York. “If financial crises tend to happen every seven years, it’s about time we start getting worried about possibly the next one.”

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