Morgan Stanley Sees Bond Evolution in Trade Jump: Credit Markets

Corporate-bond trading volumes are surging to the highest ever to start the year as investors adapt to a new reality of reduced dealer balance sheets by turning to electronically exchanged debt and smaller transactions.

Even as issuance of the securities slowed, the amount of investment-grade and junk bonds changing hands increased to $20.3 billion on average each day this year, 3 percent more than during the same period in 2013, Financial Industry Regulatory Authority data show. Bond investors are turning to exchange-traded funds at a record pace, with BlackRock Inc.’s junk-bond ETF posting record withdrawals and the greatest volume of bearish wagers ever.

The trading surge is part of a bond-market evolution that Morgan Stanley strategists led by Sivan Mahadevan say is allowing debt buyers to maneuver without Wall Street’s biggest banks using their own money to buy and sell in bigger blocks. As the size of trades shrink, investors are transacting about 50 percent more than five years ago, the analysts said in a Feb. 13 report.

“We’ve seen an increase in trading volumes despite the fact that dealers are devoting less of their balance sheets,” Mahadevan said in a telephone interview. “We’ve seen a more efficient market, more velocity of trading.”

Issuance Declines

Corporate-debt volumes have been higher this year than in any other similar period and are up from the average $18.1 billion that changed hands daily in 2013, according to Trace, Finra’s bond-price reporting system. Transactions jumped even as the amount of U.S. corporate-bond sales, which typically fuel volumes, fell to $190.1 billion this year from $218 billion in the period in 2013, Finra and Bloomberg data show.

Buyers exchanged $58.1 billion of debt on MarketAxess Inc.’s electronic platform last month, 15 percent more than in January 2013 and the most ever for the month, according to data on the New York-based firm’s website.

“Despite the banks’ unwillingness to commit capital to facilitate client trading, people are still finding ways,” said Kevin McPartland, head of market structure research at financial-research firm Greenwich Associates. “There are new ways that are not necessarily your traditional electronic trading ways.”

Less Volatile

Corporate bonds have benefited this year from a flight to fixed-income assets amid signs that a pullback in U.S. monetary stimulus threatens to weaken economies from South Africa to Russia. Even speculative-grade corporates have gained 1.4 percent this year, as measured by the Bank of America Merrill Lynch U.S. High-Yield Index, while the Standard & Poor’s 500 Index of stocks has lost 0.7 percent.

Company-bond prices have been less volatile than in the period last year, with values swinging by 1.47 cents on the dollar, a narrower swing than in the same period during the past two years. Prices have been steadied by both declining benchmark Treasury yields and increased demand from institutional money managers as individual investors fled riskier assets.

Buyers from retirees to hedge funds yanked as much as $1.7 billion from the 10-biggest junk-bond ETFs in the two weeks after Jan. 22, the day before a report showing that a gauge of China’s manufacturing contracted and triggered the selloff, Bloomberg data show.

BlackRock ETF

BlackRock’s $13.2 billion junk-bond ETF reported a $630 million outflow on Feb. 3, its biggest one-day withdrawal since its inception in 2007, the data show.

Investors including Western Asset Management Co.’s Michael Buchanan saw the outflows as a buying opportunity.

“We were buyers on days of weakness,” Buchanan, who oversees $127 billion of credit investments at Western Asset in Pasadena, California, said in a Feb. 4 telephone interview.

Debt traders who wanted to bet against junk bonds borrowed $3.87 billion of shares in BlackRock and State Street Corp.’s high-yield ETFs as of Jan. 31, according to data compiled by Bloomberg. The two funds are the biggest of their kind and hold $23.6 billion of the securities.

Investors are managing to slip in and out of a market even with the diminished balance sheets of dealers, which traditionally have bought larger pools of bonds that they could sell over a longer period of time at a profit. The strategy, credited with cushioning price swings and facilitating larger trade sizes, was made costlier by regulations demanding a bigger buffer of capital to protect against losses among bank holdings.

Dealers Shrink

Bond dealers jettisoned assets to comply with rules issued in 2010 by the Basel Committee on Banking Supervision and the Dodd-Frank Act passed by Congress the same year. Primary dealers that trade directly with the Federal Reserve cut their holdings of corporate bonds by 76 percent from a peak of $235 billion in 2007 to $56 billion at the end of March, Fed data show.

Investment-grade bond holdings fell to a net $12.5 billion in the week ended Feb. 5 from $14.4 billion the previous week, according to Federal Reserve Bank of New York data.

Even as total trading volumes fell behind a 91 percent growth in corporates outstanding since 2008, investors are adapting, the Morgan Stanley strategists said this week. They’re trading 53 percent more frequently than they did five years ago and larger trades were 8 percent smaller in 2013 than three years earlier, the analysts wrote.

While electronic platforms are unlikely to dominate a business that’s often conducted over the phone and in e-mail messages, some slices of the market are trading more like equities and interest-rate products than they have in the past, they said in the report.

“Transparency and electronic platforms are driving a credit-market evolution that is likely still in the beginning of a multi-year process,” the strategists wrote. “The market landscape has shifted in favor of investors, at the expense of dealers.”

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