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Bond Traders Stymied by Gridlock Turn to Swaps: Credit Markets

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There’s a little silver lining for banks in the lack of liquidity in credit markets: the opportunity to peddle derivatives that mimic debt securities as a fix.

Trading in total-return swaps linked to bond indexes has surged to $4 billion a week, up from $2.4 billion a year ago, according to data compiled by BNP Paribas SA. JPMorgan Chase & Co. forecasts trading of the derivatives, which are meant to make it easier to place bullish and bearish bets in credit markets, will increase by as much as threefold this year.

The swaps are gaining traction in part because investors are finding it harder to buy and sell the bonds themselves. Liquidity is declining as regulations introduced to reduce risk-taking deter banks from holding the inventories of securities they need to make markets.

“The number-one draw is that you can buy one swap and have access to about 1,000 bonds in an index, some of which have virtually no liquidity of their own,” said Daniel Zraly, who trades total-return swaps and exchange-traded funds at BNP Paribas in New York. “In buying the swap you gain exposure to the broad market and you may end up using less capital than if you bought a fully funded credit product like a bond.”

‘Alarm Bells’

Total-return swaps amplify gains or losses because they allow investors to wager on a large pool of debt while setting aside a relatively smaller amount of collateral to back the trade. They also let buyers get returns tied to assets without having to own them.

The derivatives appeal to investors because trading bonds or loans can be time consuming and expensive.

The average number of dealers providing prices for European corporate bonds dropped to 3.4 per trade last month, down from 8.8 in 2009, according to data compiled by Morgan Stanley. Pacific Investment Management Co. and BlackRock Inc. are among firms that have met in recent months to discuss proposals intended to increase liquidity in U.S. debt markets.

“Swaps linked to bond indexes can help facilitate greater liquidity in bond markets but investors should listen for alarm bells and watch with caution the rapidity of the growth,” said Lawrence Goodman, president of the Center for Financial Stability in New York.

Counterparty Risk

Like with credit-default swaps, the derivative contracts blamed for exacerbating the 2008 financial crisis, total-return swaps include the risk of one party failing to honor the agreement. The rescue of American International Group Inc. in 2008, one of the largest traders of credit derivatives at the time, helped prompt regulators to standardize trading and settlement processes to reduce this risk.

While most swaps are required to pass through clearinghouses, total-return swaps linked to the iBoxx indexes are not currently cleared, according to Markit Group Ltd.

“That means trading volumes will be concentrated with just a few counterparties rather than spread among many participants as is now the case with credit-default swaps,” said Peter Tchir, the New York-based head of macro strategy at Brean Capital.

While total-return swaps have been around for years, trading of derivatives linked to Markit’s iBoxx bond indexes have only gathered pace since standardized contracts were created in June 2012.

New Trader

Goldman Sachs Group Inc. started trading the swaps in Europe last March, while Bank of America appointed Matt Bristow as its first trader of the derivatives in London in January, according to people familiar with the matter, who asked not to be identified because the information is private. The lenders are now among six primary dealers, which also include BNP Paribas SA, Credit Suisse Group AG, JPMorgan and Morgan Stanley, according to Markit.

Bristow will also retain his responsibility for trading credit-default swap indexes, said the people familiar. Saima Farooqi, a London-based spokeswoman for Bank of America, declined to comment on Bristow’s new role.

In a total-return swap, buyers pay the London interbank offered rate and get paid if the bond index price rises over the period of the contract. Sellers receive Libor plus income if the bond index price declines.

In the U.S., as much as $3 billion of the swaps change hands each week, BNP Paribas estimates. Volumes in Europe have doubled in the past six months to as much as $1 billion a week.

Markit plans to report all confirmed swap trades on its iBoxx indexes from March 30 to the Depository Trust & Clearing Corp.’s Trade Information Warehouse, said James McLoughlin, Markit’s head of credit derivative processing. DTCC, which operates a central repository for the market, will start publishing trade data for total-return swaps as it does for credit-default swaps, said Harriet Leatherbarrow, a DTCC spokeswoman employed by Greentarget.

“With market standardization and a critical mass of dealers supporting liquidity we see this product growing in volume,” said Bryan Mix, head of European flow credit trading at Goldman Sachs.

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