Wall Street Dodging Bonds Lifts Risk in Tapering: Credit Markets
Wall Street’s biggest banks are demonstrating an unwillingness to wager on corporate debt in times of stress, raising concern that any losses will be magnified when the Federal Reserve tapers its record stimulus.
As speculation mounted in the two weeks ended Oct. 9 that the U.S. could default on its debt, the 21 primary dealers that trade directly with the central bank sold a net $180 million of investment-grade notes, Fed data show. The flight was bigger four months ago as the market spiraled into its worst performance since the financial crisis, with dealers slicing inventories by a net $4.77 billion.
Banks that traditionally sought to profit from debt-market dislocations now are shunning risk during periods of deteriorating sentiment as they eliminate proprietary trading groups and reduce leverage. Dealer reluctance to use balance sheets to absorb investment-grade credit amplified the 4.98 percent loss in May and June on the Bank of America Merrill Lynch U.S. Corporate Index as central bankers considered reducing the monthly bond purchases and Treasury yields soared toward a two-year high, New York Fed researchers wrote in an Oct. 16 report.
“There is a heightened sensitivity on dealer desks for risk at any given time,” said Jason Rosiak, the head of portfolio management at Newport Beach, California-based Pacific Asset Management, the Pacific Life Insurance Co. affiliate that oversees about $4.3 billion. “Portfolio managers can no longer rely on the dealer community as insulation to market movements and therefore that equates to more volatility.”
Corporate-bond prices are experiencing bigger swings as policy makers debate slowing the economic stimulus that’s boosted the Fed’s balance sheet to $3.8 trillion. The central bank may start reducing bond purchases as soon as December, according to 59 percent of 41 economists in a Sept. 18-19 Bloomberg survey.
After cutting a broad measure of corporate and some asset-backed debt from a peak of $235 billion in October 2007, dealers pared investment-grade holdings to a net $11.5 billion as of Oct. 9, Fed data show. That’s down from $13.5 billion at the end of May, when Fed Chairman Ben S. Bernanke said sustainable labor-market progress could prompt a reduction in the $85 billion of monthly bond purchases through the quantitative easing program.
The Bank of America Merrill Lynch U.S. Corporate Index lost 0.15 percent in the two weeks ended Oct. 9 with a partial government shutdown shaving at least 0.6 percent from fourth-quarter gross domestic product growth, Standard & Poor’s said.
“Most desks take on a lot less risk than they used to,” said David Tawil, the co-founder of Maglan Capital LP, a New York-based hedge fund that oversees $60 million. “That’s especially true when they start to see some turmoil or volatility coming. ”
Banks are less able to generate debt-trading income using their own capital because of the Dodd-Frank Act’s so-called Volcker rule, which aims to prevent such activity. Goldman Sachs Group Inc. reported a 47 percent plunge in bond trading in the three months ended Sept. 30 and Citigroup Inc. (C) said debt-trading revenue slumped 26 percent in the period.
Fixed-income trading revenue at the biggest U.S. firms probably fell 20 percent in the third quarter from a year earlier in the face of lower volumes, according to Richard Staite, an analyst at Atlantic Equities LLP.
Fed data show primary dealers sold a net $5.6 billion of investment-grade bonds in May and June, with the notes declining more than at any time since the two months ended Oct. 31, 2008, when credit markets seized up following the collapse of Lehman Brothers Holdings Inc.
“Dealers with greater ability to take on risk prior to the selloff actually sold off more,” analysts including Tobias Adrian and Michael Fleming, vice presidents in the New York Fed’s research and statistics group, wrote in the report. “This relationship suggests that dealer behavior during the selloff appears to have been driven more by differences in risk appetite than by regulatory constraints.”
Wall Street’s biggest banks are failing to buffer against price swings on investment-grade debt that are 1.5 times bigger than last year’s, Bank of America Merrill Lynch index data show. After rising as high as 113.38 cents on the dollar on May 2, prices on investment-grade bonds in the U.S. dropped as low as 103.98 cents on Sept. 5, Bank of America Merrill Lynch index data show. That compares with last year’s high of 114.8 cents and low of 108.6 cents.
The biggest decline in primary dealers’ net fixed-income holdings this year occurred between May 8 and July 17, suggesting they reduced market-making activities during the selloff, according to the New York Fed’s research.
The only other years in which there were larger changes in both long and short positions “are limited to a small number of periods at the height of the financial crisis in 2008, during the bond market selloff of 1994, and around the financial market turmoil of 1998,” the Fed researchers wrote.
The biggest banks need to reduce risk-weighted assets by more than 25 percent under new capital rules passed in 2010 and lower compensation pools for fixed-income, currencies and commodities employees by more than 20 percent, according to estimates by Sanford C. Bernstein & Co.
Fed data show Wall Street’s biggest banks cut investment-grade holdings by a net $2.77 billion in August as the Bank of America Merrill Lynch U.S. investment-grade index lost 0.7 percent.
“Less of the revenue of a bank comes from portfolio positioning and more comes from lending,” said Zane Brown, a fixed-income strategist at Lord Abbett & Co. in Jersey City, New Jersey. “It means Dodd-Frank is working and the profits of banks will have less to do with trading risks and more to do with loan risk.”
Average daily trading of dollar-denominated investment-grade bonds declined to $9.3 billion that month, 4 percent below volumes in August 2012, even as the market for the notes grew by 11 percent over the year, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, and Bank of America Merrill Lynch index data.
“As the inventories fell, liquidity dried up in the corporate-bond markets and trade volume fell,” Brad Hintz, an analyst at Bernstein, wrote in an e-mail. “Old fashioned ‘flow trading’ in credit is largely dead.”
While the dollar-denominated, investment-grade bond market has increased 71 percent since 2008 to about $4.3 trillion, the size of each transaction declined to about $565,000 in the three months ended June 30, compared with about $970,000 in the first three months of 2007, Trace data show.
“Dealers are not positioned to act as the system shock absorbers they used to be,” said Jon Duensing, a managing director at Amundi Smith Breeden, the U.S. subsidiary of the French asset-manager Amundi that oversees about $1 trillion. “If we experienced an environment where investors were attempting to move capital through a narrower pipeline, that could create some dislocation.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. decreased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 0.26 basis point to a mid-price of 71.1 basis points as of 10:43 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
A gauge of the health of U.S. financial conditions rose. The Bloomberg U.S. Financial Conditions Index, which combines everything from money-market rates to yields on government and corporate bonds to volatility in equities, added 0.05 to 1.53. The gauge, which rises as conditions improve, reached 1.54 on Oct. 16, the highest in data dating back to January 1994.
Bonds of Verizon Communications Inc. (VZ) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 6.6 percent of the volume of dealer trades of $1 million or more, Trace data show. The New York-based telephone carrier raised $49 billion on Sept. 11 in the largest corporate bond issue ever.
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