Dealers in Debt Pare Commitments Raising Risk as Rules Bite
The worst losses in U.S. debt in at least 37 years are being magnified by investors exiting the market at the same time new regulations prompt Wall Street firms to cut back on trading corporate bonds.
Bank of America Merrill Lynch’s U.S. Broad Market Index is on pace to drop 4.41 percent, the biggest annual loss since at least 1976. Investors pulled $123 billion from bond funds since May, according to TrimTabs Investment Research.
Trading in corporate fixed-income securities is the lowest ever as a proportion of outstanding debt, and volumes in Treasuries are little changed from 2007 levels even though the market has almost tripled to $11.5 trillion, Financial Industry Regulatory Authority and ICAP Plc data show. Bonds are getting riskier even with inflation at bay and corporate profits hitting new highs.
“When bond investors start to meaningfully divest themselves of their positions, it will be analogous to yelling fire in a crowded theater,” Michael Underhill, the chief investment officer at Capital Innovations LLC, which manages $1.5 billion, said in an e-mail Aug. 23.
Investors say it’s becoming harder to quickly exit positions as banks cut inventories and curb riskier businesses such as trading (NTMBIV) with their own money to comply with rules from the Basel Committee on Banking Supervision and the U.S. Dodd-Frank Act.
Money managers who used an average of seven dealers for the biggest purchases and sales of investment-grade securities in 2009 now say they need nine or 10, according to Stamford, Connecticut-based financial advisory firm Greenwich Associates.
Dealers globally have cut more than 500,000 jobs in the past five years. The credit-default swaps market has contracted 29 percent to $2.14 trillion of net outstanding positions since October 2008, reflecting the reduced trading, according to data maintained by the Depository Trust & Clearing Corporation.
The shrinking derivatives market makes it more difficult for dealers to hedge, reducing their willingness to own bonds, according to Jeff Meli, the co-head of fixed-income, currencies and commodities research at Barclays Plc in New York.
“The question isn’t how much risk you can move in a good market, but how much risk can you move in a down market,” Meli said in a telephone interview Aug. 26. “Liquidity will remain challenging. The forces that are pushing liquidity lower will only get more severe.”
That’s especially concerning to investors following a borrowing binge spurred by the Federal Reserve, which has kept interest rates near zero since Lehman Brothers Holdings Inc. collapsed in 2008 and pumped more than $2.5 trillion into the financial system. It’s currently buying $85 billion of bonds every month.
The face value of securities in the Bank of America Merrill Lynch U.S. Broad Market Index has grown to $19.2 trillion, up 61 percent from $11.9 trillion at the end of 2008. Speculative-grade, dollar-denominated debt now exceeds $2 trillion, doubling the past seven years, according to Morgan Stanley.
Bond investors, after enjoying annualized returns of 6.3 percent from the end of 2008 through last year, are now suffering as the Fed considers reducing its stimulus.
Yields (USGG10YR) on 10-year Treasury notes, a benchmark for everything from company bonds to mortgages, jumped to 2.93 percent on Aug. 22, the highest level since July 2011. The yield was at 2.89 percent as of 10:11 a.m. in New York, up from this year’s low of 1.61 percent on May 1. The price of the benchmark 2.5 percent note due August 2023 dropped 28/32, or $8.75 per $1,000 face amount, to 96 21/32, Bloomberg Bond Trader prices show.
Government bonds have retreated on the Fed’s plans, not because of inflation. The Commerce Department’s price index tied to spending, a gauge tracked by Federal Reserve policy makers, increased 1.4 percent in July from the same period in 2012.
Yields ended Aug. 30 at 2.79 percent, down 3 basis points on the week, or 0.03 percentage point, as the threat of a military conflict with Syria bolstered demand for government debt as a refuge.
Corporate bonds yields in the U.S. rose to 4.18 percent on Aug. 30 from a record low of 3.35 percent on May 2, Bank of America Merrill Lynch indexes show. Borrowing costs rose even as companies grew more creditworthy. Earnings of Standard & Poor’s 500 companies surged to more than $100 per share last year from about $60 in 2008 and default rates hold below 3 percent.
Borrowing costs may rise even more. Treasury 10-year yields will jump to 3.2 percent by the end of next year, based on the median estimate of 51 economists and strategists surveyed by Bloomberg. In April, the forecast was for 2.8 percent.
Investors are pulling unprecedented amounts of cash from bond mutual and exchange-traded funds after pouring $1.2 trillion into them in the three years after 2009, according to an Aug. 20 report from TrimTabs in Sausalito, California.
“The magnitude of the recent Treasury yield moves has surprised a lot of people,” Yvette Klevan, a global fixed-income money manager at Lazard Asset Management, which oversees $155 billion worldwide, said in an interview at the firm’s New York office Aug. 20. “What is different this time compared to other points in history is liquidity, and the fact that the sell-side dealers have less appetite to use their balance sheets” to facilitate trading, she said.
At an average of $313 billion this year, the amount of Treasuries traded through London-based ICAP, the world’s largest interdealer broker, is little changed from the $301.4 billion in 2007. In that time, the amount of marketable Treasuries outstanding has grown to $11.5 trillion from $4.34 trillion.
The 21 primary dealers authorized to trade with Fed have cut corporate-debt holdings 27 percent, to $14 billion on Aug. 21, from $18.7 billion on April 3. That follows a 76 percent reduction in inventories from the peak in 2007 through March, when the Fed changed the way it reported the data.
Inventories equal less than 0.5 percent of company debt in the U.S., Fed and Bank of America Merrill Lynch index data show.
“Markets are very thin,” said Lazard’s Klevan. “We are now in an environment where technicals and pricing dislocations are being impacted by this liquidity situation.”
That’s a small price to pay for regulations necessary to protect markets, said Anat Admati, the George G. C. Parker Professor of Finance & Economics at Stanford University’s business school in Stanford, California.
“We need to enable things to happen in the market at the right price,” Admati said in an Aug. 27 telephone interview. When markets “are a little bit less fragile, meaning everyone involved is not in as much risk of distress and insolvency, then they will be more useful,” she said.
Banks are setting aside more money to cover bad loans and cope with downturns to comply with rules aimed at preventing U.S. taxpayers from having to bail them out like during the credit crisis, when financial institutions globally suffered more than $2 trillion of credit losses and writedowns.
Internationally, capital rules passed by the 27-country Basel Committee in 2010 require lenders reduce compensation pools for fixed-income, currencies and commodities groups by more than 20 percent, and cut risk-weighted assets by more than 25 percent, according to estimates by Sanford C. Bernstein & Co.
“Dealers, given all the regulatory rules, can’t put as much capital out to hold bonds now,” said Andrew Richman, director of fixed-income at SunTrust Bank’s private wealth management unit in West Palm Beach, Florida. “All of this is affecting the pricing in the market,” he said Aug. 2 in a telephone interview.
Banks have reduced 505,339 jobs since the end of 2008, according to data compiled by Bloomberg. The securities industry in New York City employed 169,700 as of December, regaining 30 percent of the 28,300 jobs eliminated during the recession, according to New York State Comptroller Thomas P. DiNapoli.
Cutbacks are also evident in the repurchase, or repo, agreements that are used by banks and investors to borrow and lend Treasuries, corporate bonds and other collateral. That market has shrunk by 40 percent to an average of $2.6 trillion in daily securities outstanding, from $4.3 trillion in the first quarter of 2008, according to Fed data.
Corporate-bond trading dropped to a daily average of $14.8 billion since June from $19.4 billion earlier in the year, according to data from Trace, the bond-price reporting system of Finra. Volumes are equal to about 0.28 percent of the debt outstanding, the smallest proportion ever.
Credit-default swaps contracts protecting against individual borrowers missing payments have fallen 42 percent since October 2008, to a net notional $919 billion on Aug. 23, DTCC data show.
Prices of bonds in the Bank of America Merrill Lynch U.S. Broad Market Index have swung by 6.65 cents this year compared with 3.4 cents last year and 6.29 cents in 2011. Volatility in Treasuries as measured by the bank’s MOVE index has averaged 89 since July 1, compared with more than 60 in the first six months of the year.
“It’s a question of ‘buyer beware’ now,” Jason Brady, a fund manager who helps oversee about $89 billion of assets at Thornburg Investment Management Inc. in Santa Fe, New Mexico, said in a telephone interview on Aug. 14. “What is clearly the case is a liquid market is not really developing.”