Liquidity Splits Bond Market Most Since Crisis

Investors’ preference for the most-liquid corporate debt is running higher than any time since the credit crisis, a signal they’re preparing for the four-year rally to end.

The expense incurred by credit traders to complete bond transactions was the lowest last year relative to costs implied by the market’s average bid-ask spread since 2009, according to Barclays Plc. The shift, a sign that buyers are favoring securities that are easiest to trade, has helped financial bonds beat industrial debt by the biggest margin on record, Bank of America Merrill Lynch index data show.

While the focus on the most-liquid bonds has added to their gains, it’s also positioned them for steeper losses when demand deteriorates. Pacific Investment Management Co.’s Bill Gross recommended against buying corporate bonds after the extra yield investors demand to hold them rather than government debt declined 5.85 percentage points since the end of 2008.

“You had this area where people were concentrating their positions,” Bradley Rogoff, head of global credit strategy at Barclays, said in an interview in New York. “It creates more upside and downside.”

Liquidity has been stifled as some investors hoard bonds with prices rising 4 percent last year, the most since 2009, and as dealers reduce inventories in response to risk-curbing regulations aimed at averting another credit seizure.

Default Swaps

“I don’t think the environment will change any time soon,” said Brian Machan, a money manager who helps oversee $433 billion at Aviva Investors North America Inc. in Des Moines, Iowa. “You’re going to want to look at bonds that you can actually trade. From traders’ standpoint, they’re not going to short a bond they don’t think they can get back.”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose for a third day. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, increased 0.5 basis point to a mid-price of 87.1 basis points as of 12:07 p.m. in New York, according to prices compiled by Bloomberg. The benchmark has climbed from 84.9 on Jan. 7, the least since Sept. 14.

The measure typically rises as investor confidence deteriorates and falls as it improves. The contracts 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.

Rate Swaps

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.25 basis point to 13.75 basis points as of 12:08 p.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Bank of America Corp. are the most active dollar-denominated corporate securities today, accounting for 7.5 percent of the volume of dealer trades of $1 million or more as of 12:09 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Corporate-bond funds that received $20.66 billion of deposits last year are funneling cash into bonds that trade most frequently, which have the narrowest bid-ask spreads and are easiest to sell if managers need to raise cash.

‘Index Eligible?’

Upon receiving an offer to buy bonds that seem attractive on a yield basis, “the first question is always, ‘Is it index eligible? Is it liquid?’” said Rajeev Sharma, a fixed-income money manager at First Investors Management Co. in New York.

Actual investment-grade bond trading costs were 37 basis points lower than the implied expense based on average bid-ask spreads in the fourth quarter of 2012, Barclays data show. The gap between the two measures was about the same as in the three months ended June 30, the widest since the period ended three years earlier, according to the data.

The data, which derives transaction costs from bid-ask spreads and bond duration, shows that investors are focusing on notes that are easiest and cheapest to sell in the face of higher transaction costs than two years ago, Barclays analysts Jeffrey Meli and Alex Gennis in New York wrote in a Jan. 4 report.

Financial bonds, which Barclays calls the most-liquid portion of the dollar-denominated index, gained 15 percent last year, 6.5 percentage points more than industrial debt, Bank of America Merrill Lynch index data show.

Seeking Flexibility

The price of bank bonds on the financial index reached 110.3 cents on the dollar on Dec. 31, a 9.5 percent increase from the end of 2011. That compares with a 3.9 percent price rise on investment-grade notes during the period, which ended the year at 113.3 cents.

“We have tried to get more involved in liquid names, and that was a result of the credit crisis for sure,” Sharma said. “You didn’t want to be in a place where you couldn’t get out of certain names.”

Buyers are seeking flexibility as a 6 percent increase in trading volumes fails to keep up with a 13 percent rise in the size of the dollar-denominated market, data from Bloomberg and Bank of America Merrill Lynch show.

The average daily volume of bonds changing hands last year accounted for 0.29 percent of outstanding debt, the lowest proportion since at least 2005, according to data compiled by Bloomberg and Trace.

The 21 primary dealers with the Federal Reserve, which traditionally used their own money to facilitate trading, have reduced their corporate-bond inventories 76 percent since October 2007 to $57.49 billion, Bloomberg data show.

‘A Corset’

The rally in U.S. investment-grade debt may be waning with the securities losing 0.125 percent this month through Jan. 8, the third consecutive month of declines for the longest stretch since 2008, Bank of America Merrill Lynch index data show. The debt gained 55.6 percent in the four years ended Dec. 31.

Spreads on the bonds have tightened 8 basis points this month to 145 basis points, matching a three-year low, even as U.S. government debt, a common corporate-bond benchmark, has lost 0.6 percent.

Corporate-bond spreads are “so thin that they must be using a corset -- or the Fed,” Pimco’s Gross, manager of the world’s biggest bond fund, said in a message posted on Twitter. “Don’t buy them.”

Strategists at firms from Goldman Sachs Group Inc. to Bank of America Corp. forecast slowing returns, with each predicting a 1.6 percent gain in U.S. investment-grade notes this year, according to reports from the lenders. That compares with average annual returns of 11.6 percent since 2008, Bank of America Merrill Lynch index data show.

Deteriorating liquidity “hasn’t been noticed as much because the demand for corporate bonds has been kind of muting it,” said Mirko Mikelic, a money manager at Fifth Third Asset Management in Grand Rapids, Michigan, in a telephone interview. “Once people start dumping bonds, then you’ll start noticing it.”

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