Wall Street bond-trading desks are shrinking as banks hold more capital. The liquidity they provided may be missed

September 10, 2013 7:31 pm

Markets: The debt penalty

By Tracy Alloway in New York

Wall Street bond-trading desks are shrinking as banks hold more capital. The liquidity they provided may be missed

When Lawrence McDonald traded junk bonds at Lehman Brothers, he was one of a dozen traders and more than 20 salespeople on the floor. Five years after the bank’s collapse, the old Lehman desk has been folded into Barclays. But the combined Lehman-Barclays bond department is a far smaller operation than the one Mr McDonald knew. Across Wall Street, bond-trading desks have been shrinking. So has the amount of company money they are allowed to use in their daily business of buying and selling corporate bonds. “I know one trader who used to have $2bn of balance sheet. He now has $20m of balance sheet,” says Mr McDonald, now a strategist at Newedge, the broker.Buffeted by new regulations and scarred from their near-death experience during the financial crisis, big banks have quietly retreated from the business of dealing in corporate bonds. This has reduced the amount of bond risk lurking on the banks’ balance sheets. But some in the industry are worried that this shift in the structure of the $9.2tn market for companies’ debt could help sow the seeds of a new financial shock.

Since September 2008, investors have poured $524bn into investment-grade corporate bond funds alone, hoping to find better yields at a time when interest rates are at record lows. The lure of higher returns has attracted big investors such as pension funds and insurers and led to the creation of new types of funds to replicate fixed-income assets.

At the same time, the amount of corporate bonds held on the balance sheets of the dealer banks, which include Wall Street stalwarts such as Goldman Sachsand JPMorgan Chase, has dropped sharply. Dealers’ inventories of corporate debt and other non-US Treasury bonds have fallen 78 per cent since their 2007 peak of $235bn, according to Federal Reserve data. “There’s been a structural change in liquidity in the fixed-income markets,” says Dan Fuss, vice-chairman of Loomis Sayles. “The major dealers do have a tighter ‘risk budget’ now. They really do.”

Liquidity is the lifeblood of any well-functioning market. It lets investors dart quickly and easily into and out of positions without significantly moving the price of the securities they are buying or selling. A dearth of liquidity contributed to the global financial crisis as banks were unable to offload billions of dollars’ worth of complex assets tainted with the stench of failing subprime mortgages.

Unable to sell the securities or raise financing against them in the “repo market”, banks were eventually forced to take big writedowns on the positions.

The risk embedded in corporate bonds has now been shifted from the banks to investors. From a regulator’s standpoint, this means banks are less likely to require a bailout. Instead of pain being inflicted on taxpayers, investors will feel it.

But with interest rates able to move in only one direction – up – many bankers and asset managers are warning that investors who have built up corporate debt positions worth billions of dollars may find the exit crowded when the great 30-year bull run in bonds finally comes to an end.

“When the big funds come in and sell there’s just nobody there,” says Mr McDonald.

Ask a banker what the problem is and they will direct you to a host of industry developments that have sucked liquidity out of the fixed-income world. Chief among these is the introduction of rules by international and US bank regulators aimed at preventing a rerun of the kind of mayhem experienced five years ago.

The Basel committee of bank supervisors has mandated banks worldwide to hold more regulatory capital against their riskier assets, making it more expensive for them to keep such securities on their balance sheets.

Supplementary leverage ratios proposed by US regulators also force banks to set aside extra money to cover all the assets on their balance sheets, regardless of riskiness. That could force them to reduce their activities in the “repo market”, where banks and other financial companies loan out their assets in exchange for cash. “We do think it [the proposed leverage ratios] will have an impact on the repo market and on liquidity,” says Ruth Porat, chief financial officer of Morgan Stanley.

A presentation made to the US Treasury Borrowing Advisory Committee in July describes repo as the “silently beating heart of the market”. It adds that a shrinking repo market could further decrease liquidity in fixed-income assets. Banks in the US have been stopped from trading for their own accounts under the Dodd-Frank financial reforms. The rules prohibiting “proprietary trading” have yet to be finalised but Wall Street says it has adapted early by dismantling its once-powerful trading desks and now transacts purely on behalf of clients.

That means bond traders and salespeople – the “Masters of the Universe” and “Big Swinging Dicks” immortalised in Bonfire of the Vanities and Liar’s Poker – are no longer as prevalent, or as potent, as they once were.

“It’s two things,” says Ms Porat. “Re­gulation has meaningfully changed and firms have also meaningfully changed. The risk-taking, risk management and ‘tone from the top’ have evolved.”

Regulators, accustomed to warnings from banks about the dire consequences of new rules, are well aware of the industry’s concerns. They argue that liquidity came too cheaply before the crisis and that some shrinking of the more shadowy areas of the financial system – such as the repo market – is desirable. Banks such as Lehman depended far too much on short-term repo financing.

“To the extent that they run those market-making functions they [the banks] have too much leverage and too much short-term funding to support those operations. That’s the harsh reality,” says Sheila Bair, former head of the Federal Deposit Insurance Corporation.

But some bankers say the investor rush into corporate bonds and other fixed-income assets is part of the problem. The size of the outstanding corporate bond market has grown 42 per cent since 2008, according to Sifma data, as companies scrambled to refinance their debt in a period of historically low interest rates.

Investors, eager for juicier returns, piled in to buy the new bonds. Apple’s record-breaking $17bn bond issue this year attracted $52bn worth of orders. Verizon is set to test investor demand this week with another big debt sale that will be used to finance its $130bn acquisition of Vodafone’s stake in Verizon Wireless.

. . .

Exchange traded funds, which were once focused on replicating the performance of stocks or equity indices, have expanded to track corporate debt. The top five investment-grade and the top five junk bond ETFs total about $73bn, far exceeding dealer in­ventories, according to Fitch Ratings.

Bankers note that the booming primary market, where new bonds are sold, effectively masked the cracks in the pipes of the secondary market where the bonds change hands between owners. Instead of a vibrant secondary market, new issues have been held in big investors’ portfolios like rare museum pieces. That could increase volatility in the debt market and eventually lead to investor losses.

“It’s not that the dealer inventories have decreased so much. The problem is that the ratio of the assets under management in the fund community to the dealers’ inventory has increased dramatically,” says one senior banker at a large US bank. “All the investors have been doing is buying the new issues. Because there was such a one-way flow of money in, there was not a lot of need to rotate into other portfolios. The need for counterparty liquidity wasn’t there.”

That changed on May 22 when Ben Bernanke, the Fed Chairman, hinted that the US central bank could begin winding down the emergency bond-buying programme it launched during the depths of the financial crisis, as the US economy improves.

The idea that the Fed could begin to “taper” its debt purchases sparked a quick rise in market interest rates and a broad sell-off. Between May 22 and June 24, the yield on the benchmark 10-year US Treasury bond jumped from 2.03 per cent to 2.52 per cent, while investors pulled billions out of bond funds, including ETFs.

“When that happened, volume went to zero,” says Dan Zwirn, managing partner of Arena Investors, a hedge fund focused on special-situation lending to companies.

Even as the corporate bond market added almost $800bn in new issuance this year, daily trading volume has averaged only $18.2bn – a fraction of the market’s $9.2tn size. By comparison, the $11.3tn US Treasury market has experienced average daily trading volume of $655bn in 2013, according to Sifma data.

Many Wall Street banks have experimented with setting up electronic bond-trading platforms in the hopes of boosting turnover – and trading commissions – by mimicking the evolution that took place in the stock market in the early 2000s.

But the platforms have been slow to take off and face idiosyncratic problems related to the nature of corporate bonds. Unlike stocks, the bonds come in a wide variety of maturities and coupons, making it much harder to match buyers with sellers.

A number of investors say they are distrustful of the bank-run platforms and are waiting for a “multidealer” trading venue that can act more like a big stock exchange.

Over the summer, after the bout of volatility sparked by Mr Bernanke’s comments and as the market entered its seasonal lull, bond-trading platforms at Morgan Stanley and Goldman all but shut down rather than improve liquidity.

That prompted a search for alternative solutions. BlackRock, the world’s biggest fund manager, suggested companies standardise their bond issuance to make it easier to match buyers with sellers.

“The back-up in interest rates is a stark reminder that low rates and easy funding access by companies will not last forever,” says Richard Prager from BlackRock. “There is no silver-bullet solution and it will take more time for the fixed-income market to evolve than anyone will like.”

. . .

Lack of liquidity in the secondary bond market has led to an unusual development in the financial industry – an attempt at co-operation. Last year the buyside investors who purchase corporate bonds met in Boston with the sell-side banks that source the debt. All agreed that the structure of the fixed-income world had changed and liquidity had become an issue. They did not agree on how best to fix it.

Some officials argue that boosting liquidity in the market will only help at the margin should the corporate bond bubble burst. Regulators also suspect that banks may be lured back into their old wheeling and dealing role in the debt markets if bond prices begin to drop significantly.

Other market participants say that even then the biggest banks will be constrained by new capital rules and Dodd-Frank. “As soon as the dealer gets out of balance to a point where he can be accused of prop trading, he says I’m not doing it,” says Mr Zwirn at Arena Investors.

“The dealer firms are saying Dodd-Frank – they shout it at you,” says Mr Fuss at Loomis Sayles. “That’s true to a point but the other point is that it’s pretty clear to most of the world that interest rates are heading up.”

Sixteen months since the meeting in Boston, the industry is yet to come up with a cohesive solution to decreased liquidity in the fixed-income world, and the day of the Fed’s tightening has only drawn nearer.

“What we went through between May 22 and June 24 was kind of like a tremor. It wasn’t the earthquake, says Mr McDonald.”

Additional reporting by Michael Mackenzie and Tom Braithwaite

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Bonds: In search of greater liquidity

The one area of common ground among investors and bankers about addressing poor corporate bond liquidity is that there is no “silver bullet” solution, writes Michael Mackenzie. That has not stopped some participants in this $9.2tn market, such as BlackRock, from looking at how the US Treasury sells government debt and suggesting this is one way that could improve secondary market liquidity.

Every quarter the US Treasury announces the amount of debt it plans to sell for the coming three months across key maturities such as 10 and 30 years. The Treasury argues that it represents a predictable calendar of debt issuance that lowers the cost of issuance as investors are given notice of the government’s borrowing needs.

Such an approach, however, runs up against the desire of company treasurers to time their issuance of corporate debt when interest rates drop or there is a clamour among investors for specific types of debt.

The result of such flexibility for companies is a vast number of individual bonds with different maturities and fixed-rate coupons. Unlike common equity for a company, the profusion of individual bonds makes buying or selling these securities in the secondary market a difficult task.

A more standardised market would mean larger specific bond issues resulting in better secondary-market liquidity, argues Richard Prager, head of trading and liquidity strategies at BlackRock.

Replicating the US Treasury and selling debt at regular times, with the assistance of banks, is a development that would help to standardise the market and facilitate the type of seamless secondary trading that typifies equities, says Mr Prager.

The head of a big hedge fund says he “would think about how to push towards more standardised documentation [and] how we push incentives to create larger benchmark issues rather than many small ones”.

He also advocates looking at the US tax code, which penalises companies for reopening a debt issuance if the price has moved a modest amount.

“Do we want to take a step back and go for the immaterial benefit for the IRS? Do we want that as our law or do we want to widen that band so that companies have an incentive to reopen old issues which would help add liquidity?”