There’s a popular idea circulating on Wall Street that trading desks no longer have any money to help clients trade and that’s why it’s becoming more difficult to maneuver in the $8 trillion U.S. corporate-bond market.
The concept is rooted in recent Federal Reserve data showing dealers with a net short position in corporate bonds at the end of October, which leads people to think they have no inventory with which to trade. The development set off alarms among market participants and followers. But the data, while striking, is not a true portrayal of the health of the market.
What has been changing on Wall Street over the past few years -- and led to much hand-wringing about a deteriorating ability to trade -- is that firms have shut down their proprietary trading desks. They are also less willing to simply hedge risk with derivatives. These developments, mixed with oddly one-sided markets in the wake of trillions of dollars of central-bank stimulus, have led to all sorts of new market behaviors with unpredictable ramifications for the financial system.
But that’s not the same thing as a disappearance of classic market-making in debt. Banks still have some money on their credit-trading desks and are using it, albeit less so than in the go-go days before the financial crisis.
JPMorgan Chase’s investment-grade bond trading desk, for example, had a similar net position at the end of October as its year-to-date average, “and the desk is usually long bonds,” analysts led by Eric Beinstein wrote in a note late last week.
It’s difficult to draw conclusions from the Fed data, which is released weekly and tracks corporate-bond inventories. In the week ended Oct. 28, total holdings fell to a net negative $1.4 billion, the first time they had dropped below zero in Fed data going back to April 2013. That compares with a net long position of almost $13 billion in May.
The net figure is derived from 22 different primary dealers that trade directly with the Fed. It considers only cash bonds, not any derivatives that may serve a similar purpose for the bank. And, as JPMorgan analysts point out, each bank may report information from several different units, not just the market-making trading desk.
Meanwhile, trading volumes in high-yield and investment-grade debt have generally been increasing, albeit not as quickly as the total amount of the debt outstanding. And banks are in a better position to make a market from clients looking to sell bonds if they’re net short, because it won’t overload their risk, so having negative holdings doesn’t always indicate a withdrawal from the business.
This isn’t meant to cast a Pollyanna-ish sheen on credit trading or discount legitimate liquidity concerns. The larger point is that banks’ market-making role, as understood by investors before the 2008 credit seizure, went way beyond each trading desk and its capital level. It relied on banks’ ability to take larger positions in securities across various units, including their prop trading desks, as well as their willingness to use derivatives to offset risk. Those activities ended up being a toxic brew in 2008 when mixed in with loose mortgage standards and the pernicious securities they produced.
New regulations have tried to strip away those functions as much as possible, from international capital requirements to the Dodd-Frank Act’s Volcker rule. Banks don’t think of derivatives as a perfect hedge anymore and acknowledge they can introduce additional risks in their own right.
The bottom line is the world has changed and the bond market along with it. It follows that traditional metrics for evaluating it no longer tell the same story they once did. While a shift into the unknown is unnerving, it doesn’t pay to overreact. Investors shouldn’t read too much into the data on corporate-debt holdings or draw too many inferences about the amount of risk any one bank trading desk is taking at any given time.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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