By Tyler Durden at ZeroHedge
Yesterday, we pointed out that the industry is getting increasingly nervous about the possibility that a lack of liquidity in bond markets may indeed be the catalyst for the next collapse. Thanks to new regulations ostensibly designed to, among other things, bolster capital cushions and keep the market safe from the perceived perils of prop trading, banks are more reluctant to facilitate trading. This comes at the absolute worst possible time. Borrowing costs are so low that the Fed is basically daring companies not to take advantage, so while issuance is high, secondary market liquidity is non-existent meaning, effectively, that the door to the theatre is getting smaller and smaller and if someone yells “fire,” getting out is going to prove decisively difficult.
On the structural side, regulators have taken steps to strengthen the financial system. These include requiring key market-making institutions to strengthen their balance sheets and their funding models. Such structural improvements protect the financial system by making it less likely that banks will suffer liquidity crises or that such crises will spread contagiously from one institution to another (see below).However, many market participants expect that this will come at the expense of raising market-makers' costs, which could reinforce the liquidity bifurcation described above - although that is likely to happen to different degrees across asset classes and jurisdictions...Importantly, these trends are taking place just as demand for and dependence on market liquidity are on the rise. The new-issue bond market is expanding (Shin (2013)) and assets under the management of investment funds that promise daily liquidity are growing rapidly - as suggested by the increasing presence of exchange-traded funds in corporate bond markets in recent years (see also Box 2). Meanwhile, bond markets are concentrating as key participants, such as asset managers, shrink in number but expand in size. As a result, market liquidity may increasingly come to depend on the portfolio allocation decisions of only a few large institutions. And, more broadly, investors may find that liquidating positions proves more difficult than expected, particularly in the context of an adverse shift in market sentiment.Proprietary trading (ie position-taking for purposes other than market-making) has reportedly diminished or assumed a more marginal importance for banks in most jurisdictions. Expectations are for banks' proprietary trading to generally decline further or to be shifted to less regulated entities in response to regulatory reforms targeting these activities (Duffie (2012)). Overall, though, such a wind-down of proprietary trading will tend to limit market-makers' ability to redistribute risky positions. Combined with reduced risk-taking in the financial system as a whole, this would then further reduce market-makers' willingness to build up large inventories of less liquid assets...What do the changes in market-making described here mean for markets and policy? There are at least two key issues. First, reduced market-making supply and increased demand imply upward pressure on trading costs, reduced secondary market liquidity, and potentially higher financing costs in new-issue markets. Second is the question of how markets will behave under stress - that is, whether they will be able to function in an orderly fashion in response shocks or broad changes in market sentiment...
Exacerbating this are two things: 1) the possibility that a Fed rate hike will cause spreads to widen, 2) the fact that low borrowing costs and collapsing crude prices have combined to bring lots of HY issuance to market. The former is a problem because if history is any guide, the upcoming rate hike cycle is likely to push corporate spreads higher. The latter is an even bigger problem because if and when the day of reckoning finally comes and everyone is trying to get out at once, unloading junk might prove especially difficult.
So this is the unintended consequences of new regulatory oversight tripping over the unintended consequences of excessively accommodative monetary policy and the whole thing feeds on itself as the hunt for yield occasioned by keeping rates artificially suppressed for half a decade drives yet more investors into just the kind of securities no one will want when the liquidity crunch finally results in an epic collapse. Consider the following from Bloomberg:
In the negative-yield vortex that is the European bond market, investors are discovering just what lengths they’re willing to go to generate returns.Norway’s $870 billion sovereign wealth fund said this month that it added Nigeria and lifted its share of lower-rated company debt to the highest since at least 2006. Allianz SE, Europe’s biggest insurer, is shifting from German bunds to bulk up on mortgages. JPMorgan Asset Management is buying speculative-grade corporate debt to boost returns.With the European Central Bank’s fight against deflation pushing yields on almost a third of the euro area’s $6.26 trillion of government bonds below zero, even the most risk-averse investors are taking chances on assets and regions that few would have considered just months ago. That’s exposing more clients to the inevitable trade-off that comes with the lure of higher returns: the likelihood of deeper losses.“We are wandering into uncharted territory that’s subject to uncertainty and mistakes,” said Erik Weisman, a Boston-based money manager at MFS Investment Management, which oversees $430 billion globally…Norges Bank Investment Management, the world’s largest sovereign wealth fund, increased corporate bonds rated BBB or lower to 8.3 percent of its debt assets at the end of last year from 7.5 percent in the prior quarter, the fund said March 13…Among those assets are about $200 million of bonds issued by Petroleo Brasiliero SA. Brazil’s state-controlled oil company, the biggest corporate debt issuer in emerging markets, has seen its benchmark 2024 bonds tumble almost 10 percent since allegations of kickbacks and bribes emerged in November…Iain Stealey, a fixed-income manager at JPMorgan Asset Management, which oversees $1.7 trillion… says low borrowing costs and subdued inflation will support junk-rated corporate debt, which yields 3.6 percent in Europe…The insatiable demand for higher-yielding assets from lower-rated issuers is leaving investors prone to sudden losses.For MFS’s Weisman, the fact that yields for bonds of all types, from the most-creditworthy to the riskiest, are so historically low means that when the selloff finally does happen, it has the potential to be nasty…“This probably means we end up seeing all these reverse in a very unpleasant fashion,” Weisman said.
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That’s putting it politely. We prefer to think of it as “credit market carnage.”Courtesy Tyler Durden, founder of ZeorHedge (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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