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Not a drop to drink

6 January 2014 By Neil Unmack, Antony Currie

Scarce liquidity could be catastrophic for bondholders – and it may be up to them to do something about it. As their appetite for owning, buying and selling debt grows, that of Wall Street banks is shrinking.

Buying and selling bonds has never been as easy as it is for equities. But in the 2004 to 2007 boom, the liquidity gap closed somewhat. Investment banks more than doubled the dollar amount of corporate bonds they held on their balance sheets to $230 billion, according to New York Federal Reserve statistics. Bank of England data show corporate bond liquidity premiums were persistently below the historical average for most of 2003-2007.

That proved an anomaly. Banks’ ensuing losses and new regulations from leverage ratio restrictions to the Volcker Rule obliterated that business model. By the end of March 2013, inventory had plummeted by three-quarters to just $56 billion, around 2002 levels. Yet assets held in high-grade and high-yield corporate bond mutual funds and exchange-traded funds have almost tripled over the past six years to $1.1 trillion, according to T. Rowe Price.

Wall Street firms say they are making up for lost balance-sheet capacity by turning over trading books more quickly. But that helps bondholders little, according to data from bond trading statistics provider Trace, cited in research by T. Rowe Price. Investment-grade block trades bigger than $5 million comprised 5 percent of the market before 2007; now it’s less than 0.5 percent. Trades of $1 million or more have slipped to 2 percent from 20 percent.

Less liquidity means worse prices and a greater probability that herd-like investors sell at the first whiff of a crisis. That could come soon if the U.S. Federal Reserve starts dialling back its bond-buying program. The fact that many funds allow investors to withdraw cash at short notice means the market could be vulnerable if investors sell bonds en masse.

Bondholders can help themselves, by supporting nascent e-trading platforms – and not just ones that rely on combining a few brokers. The more comfortable investors get with putting their own data on such trading venues, the more overall liquidity should increase. And they could develop funds with longer liabilities to ease redemption pressures. If they sit on the sidelines, though, they will have to accept being stuck with bonds they no longer want.

 

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