Bond Trading Hampered as Buyers Retreat to Crowded ExitsLisa Abramowicz
The lowest volumes for U.S. corporate-bond trading since 2008 are underscoring the potential for market disruptions as regulations prompt dealers to retreat.
August trading volumes have plummeted to a daily average of $14.1 billion, down 9 percent from the corresponding period last year, even as the amount of company debt outstanding has soared by 12 percent. Bonds have lost 5 percent since the end of April on the Bank of America Merrill Lynch U.S. Corporate Index, the worst stretch since the credit crisis as the Federal Reserve considers curtailing its record stimulus.
Exiting from fixed-income securities is getting tougher as the world’s biggest bond dealers respond to new capital standards, reducing inventories of the debt by 76 percent since the peak in 2007. Even as lenders from Goldman Sachs Group Inc. to UBS AG create electronic-trading platforms, investors are failing to find relief from waning liquidity, according to a July report by the Treasury Borrowing Advisory Committee.
“You’ve got to be very wary of getting into a crowded position,” Stephen Antczak, the head of U.S. credit strategy at Citigroup Inc. in New York, said in a telephone interview. “If everybody has the same mandate, who’s going to take the other side of the trade? If far more guys are mark-to-market sensitive than they used to be and you overlay the lack of liquidity, that kind of exacerbates the problem.”
Investors are souring on the debt after pouring almost $950 billion into corporate-bond mutual and exchange-traded funds in the wake of Lehman Brothers Holdings Inc.’s collapse in 2008, when the Fed started expanding its balance sheet to suppress borrowing costs, Citigroup data show.
The unprecedented growth of funds that publish market prices of their assets daily has changed the dynamic of credit markets, with investors more inclined to redeem funds as sentiment deteriorates, Antczak said. The funds now account for more than 40 percent of the debt’s owners from about 25 percent in 2007, Citigroup data show.
While the biggest banks used to provide a cushion from plunging debt values, they’re less willing to fill that role after the 27-country Basel Committee on Banking Supervision raised minimum capital standards, boosting the cost of owning riskier assets.
“You can see the price swings being correlated to flows, with inflows and outflows showing up real time in performance,” said Jeff Meli, co-head of fixed-income, currencies and commodities research at Barclays Plc in New York. “The dealer community buffered against those swings at one point and they aren’t there anymore.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increasing 1.2 basis points to a mid-price of 83.4 basis points as of 11:35 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically rises as investor confidence deteriorates and falls as it improves. 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.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, climbed 0.13 basis point to 18.88 basis points as of 11:36 a.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 Petroleo Brasileiro SA are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.2 percent of the volume of dealer trades of $1 million or more as of 11:38 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Daily trading volumes in high-yield bonds have decreased to $4.3 billion on average this month through Aug. 19, compared with $5 billion in the corresponding period in 2012, Trace data show. Investment-grade volumes fell to $9.8 billion from $10.5 billion.
The decline marks a reversal from the first five months of this year, when average trading volumes for debt of corporate borrowers from the riskiest to the most creditworthy of $19.4 billion were 8 percent higher than last year’s pace.
While market turnover has, if anything, increased since the financial crisis, “liquidity is about much more than turnover” and has the “tendency to disappear abruptly when really needed,” according to a presentation to the Treasury Borrowing Advisory Committee that sought to assess liquidity in the fixed-income market.
Buyers pulled $7.4 billion from investment-grade funds in July, Bank of America Corp. data show, after Fed Chairman Ben S. Bernanke said the central bank could start curtailing the current pace of debt buying if growth is in line with central bank estimates. The Fed will likely reduce the central bank’s $85 billion in monthly bond purchases next month, according to 65 percent of economists surveyed by Bloomberg.
A 2.8 percent loss this year on dollar-denominated corporate debt compares with a 7.1 percent gain in the corresponding period last year, Bank of America Merrill Lynch index data show.
Corporate borrowers racing to lock in borrowing costs that averaged 4.3 percent as of Aug. 19, compared with a 10-year average of 5.82 percent, have sold $975 billion of the debt this year, expanding the size of the market to $5.3 trillion, according to Bloomberg and Bank of America data.
BlackRock Inc.’s $17.8 billion investment-grade bond ETF has eliminated 7.3 million shares this month, equal to about $825.6 million, data compiled by Bloomberg show. Its $14.6 billion high-yield ETF reported an outflow of 3.6 million of shares on Aug. 19, the biggest daily withdrawal on record.
“We expect outflows to accelerate,” Bank of America credit strategists led by Hans Mikkelsen in New York wrote in an Aug. 19 report. “With poor summer liquidity and hedging needs we retain our hedge against a disorderly rotation with wider credit spreads.”
Wall Street dealers traditionally act as middlemen by warehousing bonds until customers seek to buy them. That model is changing as U.S. and international rules meant to make the banking system safer have prompted dealers to cut the amount of debt they hold.
The 21 primary dealers that do business directly with the Fed reduced their balance sheets to $56 billion at the end of March from $235 billion in October 2007, New York Fed data show. They were holding $7.9 billion of investment-grade bonds as of Aug. 7, Fed data shows, about 0.2 percent of the market for the dollar-denominated notes.
That’s led to a concentration of credit risk in funds that take bullish positions on corporate debt, leading to more of a one-sided market than in the past, Citigroup credit strategists led by Antczak wrote in a report this month.
Goldman Sachs spent a year developing an electronic trading system for corporate bonds called GSessions that started operating in 2012. UBS, Switzerland’s biggest bank, has directed more debt trading onto its Price Improvement Network, which lets customers directly post prices with a so-called order-book model where bids and offers are shown before the trade.
While there’s been “massive growth” in electronic price inquiries, much of it is small in size, leading to little extra depth in trading, according to the Treasury Borrowing Advisory Committee report.
“Liquidity has deteriorated overall,” Barclays’ Meli said. “Transaction costs remain high. In periods of low liquidity, the cost of transaction goes up more than we used to see in similar periods before 2011.”
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