Credit Markets Are Stuck Playing Game of Dealers' ChoiceBy and
Willingness to buy debt ‘clearly being tested,’ BofA Says
Mild inflation report could quell volatility, spur demand
In credit markets, it’s dealers’ choice -- for now.
That means credit spreads are in the hands of market makers as selling pressure in investment-grade bonds refuses to fade, according to Bank of America Merrill Lynch. Dealers bought a net $1.2 billion of corporate bonds on Monday after weekly flows to high-grade funds turned negative, write a team led by Hans Mikkelsen.
Record weekly outflows from iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) are a double whammy of risk aversion and diminished appetite for duration, as this product tends to hold longer-dated debt.
Dealers absorbed an estimated $5 billion in investment grade bonds last week, according to Bloomberg Trace data. Up until that time, dealers were net sellers to clients and affiliates to the tune of about $6 billion in 2018.
While dealers help stabilize markets during dislocations, with an aim to ultimately benefit from indiscriminate selling, severe shocks can also constrain their ability to absorb risk. Those dealer desks have also endured some sizable shrinkages linked to post-crisis regulations and years of market torpor.
“With a buyers’ strike among real money investors due to elevated uncertainties, credit spreads are holding up only to the extent that dealers are willing to be net buyers of paper, a willingness that is clearly being tested,” the Bank of America strategists wrote. “We think that what it takes for spreads to tighten from here and dealer balance sheets to clean up is a meaningful reduction in vol -- such as equity vol but especially rates vol.”
That raises the stakes for Wednesday’s U.S. inflation report, they add, as a reading that’s in-line or below consensus would likely quell rates volatility and stoke demand for credit.
Otherwise, a breakout of interest-rate volatility would jeopardize the near-relentless tightening of investment-grade credit spreads since January 2016.
“Credit is a volatility product,” Nick Burns, a Deutsche Bank AG credit strategist, wrote in a Feb. 9 note, citing a relatively stable link between implied equity price swings in the U.S. and euro area and credit spreads. “Since equity volatility captures the volatility of asset valuations on corporate balance sheets, all else equal a higher equity volatility regime should lead to wider credit spread levels.”
And with a backdrop of low defaults, the relative importance of volatility as a driver of credit spreads has increased.
“To the extent that rise in volatility reflects an increase in real yields, that decreases the incentive for being invested in spread products,” Joseph Faith, credit strategist at Citigroup Inc. in London, said in a message. “Big rates selloffs also tend to be associated with negative total returns, which lead to outflows from fixed income, credit included.”