What’s Worse: Big Banks or Bondholders Shaking Markets?

Banks may have gotten safer since the 2008 credit crisis, but risk is migrating to bond buyers.

That’s worrying analysts and policy makers alike, who see investors plowing into infrequently-traded debt while Wall Street reduces its role in making markets. The combination has “resulted in a new world for investors,” one that’s fraught with pockets of less trading and bigger price swings, Royal Bank of Scotland Group Plc analysts wrote in a November report.

The U.S. Treasury Department has taken note, too, saying this week that investors pose a growing threat to financial stability.

“Markets have become more brittle because liquidity may be less available in a downturn,” according to the annual report by the Treasury’s Office of Financial Research. “Recent volatility in financial markets focused attention on some of the vulnerabilities that have been growing over the past several years.”

On Oct. 15, benchmark Treasury yields plunged the most since 2009 as investors fled riskier assets for the perceived safe haven of U.S. government debt. Implied swings in Treasury prices rose the most since 1989 that day, as measured by Bank of America Merrill Lynch’s MOVE index, showing how quickly volatility can surge from near record-low levels.

Yield Hunt

After six years of unprecedented Federal Reserve stimulus, regulators are concerned that that the easy-money policies have laid the groundwork for a mass exodus from debt when interest rates rise.

The market has shifted in two key ways since the crisis to push risk into the hands of institutional and individual investors, and away from banks.

First, investors have delved deeper into speculative-grade debt, seeking extra yield to boost returns as the central bank held borrowing costs near zero. This means investors are more exposed than ever to the companies most at risk of defaulting on their obligations.

Second, banks have been shrinking their balance sheets and staff in response to higher capital requirements and the 2010 U.S. Dodd-Frank Act’s Volcker Rule, which aims to limit banks’ trading with their own money. Less of a cushion from Wall Street balance sheets may make falling bond prices all the more painful for investors.

Trading Drop

“Policy makers have taken action to insulate the banking system and taxpayer, who suffered in the financial crisis,” John Briggs, head of cross asset strategy at RBS, wrote in a Nov. 21 report. At the same time, “investors, professional and retail, are increasingly vulnerable,” the report said.

Trading is failing to keep up with the expansion of bond markets. For Treasuries, it’s fallen 7.4 percent in 2014 from the same period last year, even though the pool of debt outstanding has expanded, according to data compiled by the Securities Industry & Financial Markets Association.

The 22 primary dealers that trade directly with the Fed have also shrunk their net inventories of high-yield bonds, historically used to facilitate trades. Holdings fell as low as a net $1.1 billion in October from $8.4 billion in June 2013, Fed data show.

Meanwhile, the market for U.S. speculative-grade securities has grown 83 percent since the end of 2008, to $1.3 trillion as tracked by Bank of America Merrill Lynch index data.

“Investors may have become too sanguine about the availability of market liquidity - the ability to transact in size without having a significant impact on price,” according to the Treasury report. “Although the dislocation that peaked in mid-October was fleeting, we believe there is a risk of a repeat occurrence.”

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