Worried About Debt-Market Liquidity? Sell Those Bank Bonds

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Call it the liquidity curse.

If rising interest rates prompt investors to flee debt markets, bank bonds could be the hardest hit among corporate securities, according to Bank of America Corp.

“We’re now moving into an environment of outflows, which means a lot of investors are going to have to sell bonds for an extended period of time,” Hans Mikkelsen, head of U.S. investment-grade credit strategy at Bank of America Merrill Lynch, said in a telephone interview.

Investors will have to ignore the fundamental fact that higher rates and a stronger economy are actually good for banks, he said, because they’ll just have to offload what they can.

Two factors make bank bonds an easy sell: they are widely owned and actively traded. A Bank of America survey of 94 credit investors last month showed a majority were overweight bank bonds. Trading in bank bonds made up more than 30 percent of the total volume of corporate debt traded in the past three months, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“Bank bonds are going to be the vehicles for redemptions in the corporate-bond market,” Mikkelsen said. “So if you own a lot of bank bonds, you risk underperforming in the next one to two years.”

Unmatched Liquidity

Investors, traders and regulators have become increasingly concerned in recent months about the ability to buy and sell bonds in the U.S. market without igniting big price moves in the event sentiment sours.

The worry spreading from Wall Street to Washington is that investors will try to sell their holdings all at once into a deteriorating market, at a time when dealers’ ability to carry out their traditional role as middlemen has been diminished by tough post-crisis regulations.

Top money managers including Vanguard Group Inc. and TCW Group Inc. are holding more cash and liquid securities so they can return money to investors who want it back.

That’s one reason bank bonds are attractive to investors. Banks including JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs Group Inc. have sold $1.3 trillion of bonds since the financial crisis, according to data compiled by Bloomberg. That’s a fifth of the total $6.5 trillion investment-grade bonds issued in that period.

Six of America’s biggest banks -- JPMorgan, Bank of America, Goldman Sachs, Morgan Stanley, Citigroup and Wells Fargo & Co. -- are among the top 11 most actively traded names in the corporate-bond market over the past three months, Trace data show.

Bank bonds in the U.S. have returned an average 7.7 percent annually since 2008, according to Bank of America Merrill Lynch index data.

“No sector has the same kind of liquidity as the banking sector,” Mikkelsen said. He said prices for bank bonds could be pushed low enough that they underperform Treasuries, which typically yield less because they are deemed safer.

(An earlier version of this article corrected the figure to $1.3 trillion in 10th paragraph.)

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