Leveraged Money Spurs Selloff as Record Treasuries Trade

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When markets are buckling and volatility is signaling a crisis, you sell what you can, not what you want.

That’s what happened last week on Wall Street, where slowing economic growth in Europe, Ebola anxiety and escalating conflicts in the Middle East and Ukraine tore through the calm with a force not seen in three years. Loath to find out what their record holdings of corporate bonds and leveraged loans were worth as liquidity thinned and markets slid, professional traders turned to stocks and Treasuries to defuse risk.

The result was a frenzy. U.S. government debt volume surged to an all-time high of $946 billion at ICAP Plc, the world’s largest interdealer broker, more than 40 percent above the previous record. About 11.9 billion shares changed hands on U.S. equity exchanges on Oct. 15, the most since the European debt crisis of 2011.

“Whenever people can’t sell their illiquid assets, they turn to the U.S. stock market because everyone is involved in it and that’s what they can sell,” said Matt Maley, an equity strategist at Miller Tabak & Co. in Newton, Massachusetts, who has worked in the securities industry for 32 years. “That’s why the market selloff was so sharp. You sell what you can, and the deepest, most liquid asset in the world is U.S. stocks.”

Rising Volatility

Equity owners were blindsided by swings that erased the Dow Jones Industrial Average’s 2014 gain and wiped out $672 billion of global market value. The 30-stock gauge swung in a 458-point range on Oct. 15, the widest since 2011. Its 263-point rally on Oct. 17 trimmed the weekly decline to 1 percent, the fourth consecutive drop.

Dow futures expiring in December lost 0.5 percent at 8:48 a.m. in New York today. Treasury 10-year yields were little changed.

Measures of turbulence soared this month. The Chicago Board Options Exchange Volatility Index has gained 35 percent in October and touched its highest level since June 2012. A gauge compiled by Bank of America Corp. tracking swings in equities, Treasuries, currencies and commodities reached a 13-month high just three months after hitting its lowest level ever.

Faster Growth

With economic data in the U.S. pointing to faster growth and earnings estimates little changed, last week was a case of anxiety breeding anxiety, said David Lafferty, the chief market strategist for Natixis Global Asset Management in Boston.

“In the investor’s mind, there can be real risk contagion -- that’s what led to the speed of the selloff,” said Lafferty, whose firm oversees $930 billion. “Risk aversion can spill from one market from another.”

Risk aversion is growing at pension funds and insurance companies that have piled into less-liquid assets as the Federal Reserve maintained unprecedented stimulus for a sixth year. Investors owned $100 trillion of debt globally in the middle of 2013, up from $70 trillion six years earlier, according to the Bank for International Settlements.

The proportion of corporate-debt securities held by mutual funds has doubled since 2007 and now amounts to 27 percent of global high-yield debt, according to an October report by the International Monetary Fund. Investors placed a record $62.9 billion last year into mutual funds that buy leveraged loans, which are mostly speculative-grade, aren’t regulated as securities and trade by appointment only, Lipper data show.

Higher Risks

The mountain of assets held by investors has “raised market and liquidity risks in ways that could compromise financial stability if left unaddressed,” according to the IMF report. “The increased sensitivity of credit markets could make the exit process more volatile, potentially undermining the ability of the financial system to support the recovery.”

The concern is the more investors buy obscure assets, the less flexible they’ll be during a market disruption. In the latest bout, they went to where the volume was, while hanging on to less-traded assets.

While Treasury trading surged, buying and selling in debt such as corporate bonds remained more than 20 percent below record levels. About $23.8 billion of corporate bonds traded on Oct. 15, equal to about 0.3 percent of the total outstanding, according to data compiled by the Financial Industry Regulatory Authority and Securities Industry and Financial Markets Association.

Providing Liquidity

While corporate-debt trading failed to approach records, there was more activity than usual. Volumes of high-yield and investment-grade bonds were 8 percent higher on Oct. 15 compared with the daily average of $22 billion since the beginning of September.

Treasuries “provided the liquidity when everyone said there wasn’t any,” said Jim Bianco, president of Bianco Research LLC in Chicago.

An average of 9.6 billion shares a day changed hands on American stock markets last week, compared with 4.3 billion in the final week in August, data compiled by Bloomberg show. Measured by the value of stock trading, a figure increased by the 179 percent rally in the Standard & Poor’s 500 Index during the last 5 1/2 years, volume was the highest since 2008.

“The sudden degradation in the bond market just led to increased volatility and risk-off sentiment everywhere,” said Virginie Robert, co-founder of asset-management firm Constance Associes in Paris. “Yields jump, markets panic, and risky assets will be the first to go.”

Fed Tapering

Almost six years after the Fed started buying bonds and holding benchmark interest rates at about zero, investors are trying to prepare for a withdrawal of easy-money policies. U.S. central bankers have been planning to end monthly asset purchases this month and have discussed raising overnight rates next year.

At the same time, the European outlook has dimmed, with consumer prices rising at the slowest pace in five years in September. The global economy will likely grow 3.8 percent next year, the IMF said this month, compared with a July forecast of 4 percent.

With the European Central Bank preparing its own stimulus, investors are faced with either settling for the lowest yields on record on government bonds or buying riskier assets.

Leverage among hedge funds that speculate on rising and falling security prices is near the highest in the past five years, data compiled by Credit Suisse Group AG show. The measure, which tracks how much fund holdings exceed the cash invested by clients, was at 2.64 in October, according to an Oct. 15 report by Mark Connors, Credit Suisse’s global head of risk advisory.

Bond Dealers

Corporate bond values are fluctuating the most in more than a year as Wall Street’s biggest banks opt against using their own money to absorb debt being sold by clients.

The 22 dealers that do business with the Fed reduced their net holdings of high-yield bonds by $1.7 billion in the two weeks ended Oct. 8 to a net $6.3 billion, Fed data show. They were joining the crowd in selling, with high-yield bond mutual funds receiving $7.4 billion of withdrawals since mid-September, according to data compiled by Wells Fargo & Co.

“Even when prices go down, it’s hard to buy paper,” said Gershon Distenfeld, the New York-based director of high-yield debt at AllianceBernstein Holdings LP. With dealers reducing their balance sheets, “you often don’t know what the price is. You can’t transact,” he said.

Credit fund managers were shaken by the move in rates, as many hedge against swings in Treasury yields to capture the extra yield tied to company risk. Traders had a record amount of bearish wagers against U.S. government debt earlier this year as they prepared for the Fed to withdraw stimulus.

Investors unwound some of those short positions last week, adding further fuel to the rally in the debt.

The market hadn’t been tested until Oct. 15 “and we failed the test,” said Michael Cloherty, head of U.S. rates strategy at Royal Bank of Canada’s RBC Capital Markets unit in New York. “Liquidity is not what it used to be.”

(Updates with today’s trading in sixth paragraph.)
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