Bond Liquidity Seen Worsening by BofA as Regulations Tighten

  • Corporate supply has begun affecting government rates: BofA
  • Indicators include Treasury futures volumes, bank says

Dwindling liquidity in bond markets may get worse next year as more regulation hits the financial industry, raising questions as to whether rules are making financial markets safer, Bank of America Merrill Lynch said.

New supply of corporate debt is having a bigger impact on government rates than in the past years, suggesting the sovereign bond-market depth has decreased, according to the report published Wednesday by the bank, one of 22 primary dealers that trade directly with the Federal Reserve.

Other signs that point to a decline in ease of trading include all-time high Treasury futures volume relative to the cash market, and “very large differentials” between generic off-the-runs, or older securities, and futures contracts on deliverable bonds, BofA Merrill Lynch said.

Chicago Board of Trade, Bloomberg

Higher costs of capital as a result of tighter regulations have forced banks to rethink their strategies. Credit Suisse Group AG last month said it would stop making a market in government bonds across Europe, raising concerns that others may follow.

Withdrawals from market-making and primary dealing, or buying directly from sovereigns, may clog bond markets when reduced liquidity already makes trading tougher for investors.

The danger is that financial markets are vulnerable to dislocations as lack of depth, including the ability to absorb supply, means they’re less capable of smoothly handling shocks that involve large transfers of risk among investors, Ralph Axel, a rates strategist at the bank, wrote in the report.

Low liquidity “potentially leads to big overshoots” in rates and spreads, Axel said. “Sub-optimal pricing likely leads to sub-optimal economic performance.”

Higher Costs

New regulations that followed the financial crisis have made it more expensive for banks to act as market makers for bonds or warehouse risk. The five largest primary dealers -- those financial institutions that trade directly with the Treasury -- have cut their balance sheets by about 50 percent from 2010, according to data from Tabb Group LLC. 

“The regulations are still being written, however, and we think there is scope for even lower market liquidity next year,” Axel said. It is “obvious” that the Dodd-Frank financial regulations resulted in “much better capitalized financial institutions better able to withstand limited access to funding markets in time of stress. But if market dislocations are twice as large when the shock comes and capital levels are twice as high, is the system really any safer?”

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