Bond Traders Left Adrift as Dealers Reduce Risk: Credit Markets

Volatility in the markets certainly contributes to the pullback in trading of corporate bond and other “story paper”. We wonder if the changes in the tri-party market, preparation for the use of Stressed VaR, and the impact of Basel III’s “Liquidity Coverage Ratio” (LCR) observation period, all of which work against financing anything but the highest quality paper, are also to blame?

By Shannon D. Harrington and Sarah Mulholland
Oct. 6 (Bloomberg) — Europe’s crisis of confidence is crippling credit-market trading as banks shrink bond inventories to the least since the depths of the last recession.

Federal Reserve data show U.S. primary dealers cut their holdings of corporate debt by 33 percent to $63.5 billion since May, bringing stockpiles to within $4 billion of the five-year low reached in April 2009. Trading in investment-grade company bonds has dropped 27 percent since February, according to Trace data compiled by Barclays Capital, and a measure of the cost to buy and sell debt reached the highest in more than two years.

Evaporating liquidity is contributing to the biggest junk- bond losses since the failure of Lehman Brothers Holdings Inc. three years ago as Europe’s leaders seek to prevent the region’s fiscal imbalances from infecting the global banking system and the U.S. economic recovery struggles to gain footing. Sales of new high-yield securities have all but disappeared and prices in debt markets are swinging by the most since 2008.

“Everything is moving very quickly,” said Tom Farina, a managing director in New York at Deutsche Insurance Asset Management, which oversees more than $200 billion. “With the experience of the credit crisis still fresh in our minds, there’s a greater appreciation for how much the market could decline over a short period of time.”

Convulsions are spreading beyond corporate debt with dealers restricting trading in bonds tied to skyscrapers, shopping malls and other types of property, according to Ellington Management Group LLC.

‘Functioning Market’

“It is very hard to get a dealer to provide good liquidity” in commercial mortgage bonds rated AA and lower, said Leo Huang, an investment manager overseeing commercial real-estate debt at Old Greenwich, Connecticut-based Ellington. “For a functioning market, you need to have a market for those bonds.”

Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds globally rather than government debentures held at the highest level since July 2009. The market for corporate borrowing in the U.S. through short-term IOUs fell below $1 trillion for the first time since February. Joy Global Inc. is offering $500 million of notes as sales decline.

Spreads on company bonds from the U.S. to Europe to Asia widened 13 basis points to 277 basis points, or 2.77 percentage points, since the end of September, according to Bank of America Merrill Lynch index data.

Riskier Assets

The seasonally adjusted amount of U.S. commercial paper outstanding dropped by $22.2 billion to $985.4 billion in the week ended Oct. 5, the 12th consecutive decrease, the Federal Reserve said today on its website. It’s the longest stretch of declines since the period ended Jan. 19 and the lowest level since the market touched $988.3 billion Jan. 26, according to Fed data compiled by Bloomberg.

A drop in short-borrowing by banks led the decline, as investors shunned riskier assets potentially affected by the European debt crisis. Commercial paper sold by non-U.S. financial institutions fell $11.5 billion, the fourth weekly decline, while the amount issued by banks based in the U.S. decreased $12.6 billion, according to the Fed.

Joy Global, the Milwaukee-based maker of P&H and Joy mining equipment, may sell 10-year notes as soon as today to back the acquisition of China’s International Mining Machinery Holdings Ltd., according to a person familiar with the offering, who declined to be identified as terms aren’t set.

Sales of dollar-denominated debt in the U.S. market for the first three days of this week decreased 74 percent to $3.4 billion from the $12.9 billion sold between Sept. 26 and 28, according to data compiled by Bloomberg.

Credit Swaps

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, decreased 4.1 basis points to a mid-price of 141 basis points at 11:51 a.m. in New York, according to Markit Group Ltd.

The Markit iTraxx Europe Index of credit-default swaps linked to 125 companies with investment-grade ratings fell 8.5 basis points to 190.5, according to JPMorgan Chase & Co. at 10 a.m. in London.

The measures, which typically fall as investor confidence improves and rise as it deteriorates, decreased as data in the U.S. signaled the pace of job dismissals is slowing and amid growing optimism grew that Europe’s leaders were making progress in plans to tame the debt crisis.

Jobless Benefits

Applications for jobless benefits increased by 6,000 in the week ended Oct. 1 to 401,000, Labor Department figures showed today. Economists projected 410,000 claims, according to the median estimate in a Bloomberg News survey. European Commission President Jose Barroso said the commission is proposing coordinated action to recapitalize banks.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The 22 primary dealers of U.S. government securities that trade directly with the Federal Reserve have reduced holdings of corporate and securitized debt lacking government guarantees from $94.9 billion at the end of May, Fed data show. Inventories peaked at $235 billion in October 2007 and fell to as low as $59.8 billion in April 2009.

Even as European leaders have vowed to stand behind the region’s banking system and prevent the sovereign debt crisis from escalating, they’ve faced domestic opposition to expanding rescue packages for the most debt-laden nations. German Chancellor Angela Merkel said yesterday Europe’s rescue fund will only be used as a last resort to save banks and that investors may have to take deeper losses as part of a Greek rescue.

‘Pulled Back’

“It makes sense that people have pulled back a little bit,” said Jeffrey Meli, head of credit strategy at Barclays in New York. “It’s harder to determine appropriate pricing for a political problem than a financial problem.”

The four-week moving average of daily investment-grade bonds traded on Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, dropped to $10.6 billion on Sept. 30, from $14.6 billion Feb. 11, according data compiled by Barclays.

At the same time, the gap between where dealers buy and sell debt has widened to the most since July 2009. The so-called bid-ask spread for the 15 most-traded credit-default swaps on U.S. investment-grade companies expanded to 18.7 basis points on Oct. 4, compared with 4.9 basis points at the end of July, according to market prices compiled by London-based CMA. That’s equivalent to $18,700 on a $10 million contract. The spread narrowed to 17.5 basis points yesterday.

Price Swings

“It’s hard to buy or sell securities right now,” said Meli. “There’s been a substantial decline in dealer balance sheets and Trace volumes have also fallen. If dealers are cutting balance sheets, there’s just less buffer capital to buy and sell securities.”

A measure of price swings over a 50-day period for high- yield bonds is at the highest since December 2008. The Barclays Capital U.S. Corporate High Yield Average OAS index reached 35.9 today, from 14.9 at the start of June.

“People are not going to buy a bond today when tomorrow it’s going to be down 5 points,” said Peter Plaut, a senior vice president and high-yield and distressed bond salesman at MF Global Holdings Ltd. in New York. “Liquidity is extremely poor.”

Junk Bond Losses

Junk bonds lost 7.5 percent in August and September according to Bank of America Merrill Lynch index data, the biggest two-month loss since the period ended November 2008. U.S. bank bonds declined 3.7 percent during the same period. Issuance of speculative-grade debt has dropped to $7.1 billion since the end of July, down 89 percent from the same period last year, Bloomberg data show.

High-yield debt is rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.

The “impaired” credit markets are particularly troubling because they’ve deteriorated even without the kinds of forced selling that took place three years ago during the crisis triggered by the U.S. housing market collapse and Lehman’s bankruptcy, according to strategists at Wells Fargo Securities.

“The credit markets have significantly less leverage now than was the case in 2008, so we have not seen the forced selling from collapsing layers of leverage in the synthetic credit markets,” fixed-income strategists led by Richard Gordon said in an Oct. 4 report.

Swap Trading

As trading in bonds seizes up, demand for credit-default swaps tied to corporate borrowers and trading partners, or counterparties, such as banks is rising.

Trading in the top 1,000 credit swaps on individual borrowers jumped to 33,471 contracts in the week ended Sept. 30, compared with a weekly average of 23,578 contracts in the six months ended in August, according to Depository Trust & Clearing Corp. data.

Banks, hedge funds and other investment firms traded 253 contracts tied to Morgan Stanley last week, protecting $2.2 billion. That compares with a weekly average of 73 contracts backing $710 million in the six months ended in August, DTCC data show. Swaps on Goldman Sachs Group Inc. traded 179 times on $1.57 billion last week, compared with an average of 91 swaps on $891.6 million.

“It’s been a difficult environment,” David Austen, head of credit sales for the Americas at Nomura Securities International Inc. in New York, said in an interview yesterday on Bloomberg TV’s “InsideTrack.” “No one’s particularly happy right now.”

–With assistance from John Parry, Erik Schatzker and Stephanie Ruhle in New York. Editors: Pierre Paulden, Alan Goldstein

To contact the reporters on this story: Shannon D. Harrington in New York at; Sarah Mulholland in New York at

To contact the editor responsible for this story: Alan Goldstein at;

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