The boom in fixed-income derivatives trading is exposing a hidden risk in debt markets around the world: the inability of investors to buy and sell bonds.
Bloomberg reports today: While futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year. In Japan’s $9.6 trillion debt market, the benchmark note didn’t trade until midday on two days last week.
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Inefficiencies in the $100 trillion market for bonds may make investors more vulnerable to losses when yields rise from historical lows. “Liquidity is becoming a serious issue,” Grant Peterkin, a money manager at Lombard Odier, which oversees $48 billion, said in a June 11 telephone interview from Geneva.
The worry is that when investors try to exit their positions, “there may be some kind of squeeze.” That concern has caused investors to pour into derivatives, which are contracts based on underlying assets that can provide the same exposure without tying up as much capital.
As bond trading has slumped, the notional value of over-the-counter contracts soared fivefold in the past decade to a record $710 trillion, based on the latest data from the Bank for International Settlements compiled by Deutsche Bank.
The shift reflects an unintended consequence wrought by central banks, which have dropped interest rates close to zero and implemented policies such as buying debt to restore demand in economies crippled by the financial crisis. Inefficiencies in the $100 trillion market for bonds may make investors more vulnerable to losses when yields rise from historical lows.
Todays Other Top Stories
LearnBonds: – Capture higher yields from crowdfunded real estate. – If the Fed’s decision to suppress interest rates for the past several years, and perhaps for years to come, is causing great harm to your income-focused portfolio, you might want to consider other opportunities. One such opportunity is real estate. But rather than dealing with the hassle of buying and managing properties yourself, you might consider using the relatively new real estate crowdfunding platforms available on the web.
Bloomberg: – Munis set for longest slide since March after debt offers mount. – The $3.7 trillion municipal market is headed for the longest losing streak since March after localities offered the most bonds in three months.
Miami Herald: – Timing may be right to consider municipal bonds. – Municipal bonds have long been a popular investment for higher-income Americans. Like other bonds they can play an important role in diversifying an investor’s portfolio, since they generate a steady stream of coupon income without the dramatic ups and downs of the stock market.
WSJ: – Detroit reaches bankruptcy settlement with some bondholders. – The city of Detroit has reached new agreements with its largest municipal union and a separate settlement with a group of bondholders, likely reducing the number of creditors to oppose the city’s bankruptcy plan at a trial scheduled for this summer.
Reuters: – Moody’s rates first TOB that passes Volcker rule. – Fears that a $75 billion corner of the municipal bond market for Tender Option Bonds would be closed down by the Volcker Rule may have been squashed with a new deal from Bank of America Merrill Lynch. The tiny $8.545 million deal has been structured to comply with Volcker Rule restrictions by using two loopholes in the Investment Company Act of 1940.
The Guardian: – The bonds holding American cities together may be in trouble. – Morningstar’s abandonment of municipal bond research shouldn’t go unnoticed. It’s bad news for many investors who have municipal bonds in their retirement portfolios – and the timing couldn’t be worse.
Bloomberg: – California lawmakers approve record $156.4 billion budget. – California lawmakers approved a record $156.4 billion budget for the most populous U.S. state after they struck a last-minute deal with Governor Jerry Brown over spending levels.
Bloomberg: – Sewage-to-fertilizer plan shows no junk bonds stink. – A central Florida facility that would convert sewage into fertilizer is the latest project to tap relentless demand for the riskiest municipal bonds.
CNBC: – Why low bond yields are all you deserve. – While bonds’ low spreads over Treasurys have spurred concerns investors may be paying too much for yield, some analysts say low payouts may be justified.
Wall St Cheat Sheet: – Is the Federal Reserve sitting on a $4.3 trillion time bomb? – When the U.S economy tripped into recession after the 2007 financial crisis, the Federal Reserve responded by buying assets in the open market in order to increase the supply of money. As a result of these bond purchases, the Fed’s balance sheet has grown to $4.3 trillion, an increase of about $3 trillion since December 2007.
Investing.com: – U.S. 10-year bonds: Speculators add to bearish positions. – Large Speculators net bearish positions rise again to a total of -71,903 contracts.
Businessweek: – Treasuries rise before Fed as Iraq drives haven demand. – Treasuries rose after back-to-back weekly declines as signs of subdued economic growth and a potential civil war in Iraq spurred demand for haven assets before the Federal Reserve meets this week.
FT Adviser: – Fund Selector: Which bonds to choose? – The last time I wrote an article in this section, its theme was about the ongoing economic recovery in the US and the response in financial markets.
Market Realist: – Why yields on investment-grade corporate bonds continued to fall. – A key statistic was the issuer preference for fixed-rate over floating rate debt—about 75.2% of total weekly debt issuance was priced as fixed-rate, compared to 24.8% as floating rate. Still, floating rate issues at $9.6 billion for the week, touched a weekly high for 2014. This implies that IG corporate issuers are looking to lock-in yields that are near record lows.
High Yield Bonds
Forbes: – High yield bond issuance surges to $9.8B amid investor cash inflow. – Amid investor cash inflows to the asset class the U.S. high yield bond market kicked into higher gear last week, posting nearly $10 billion in volume, more than double the amount seen the previous week and the most since the middle of May.
FT: – Too much of a good EM thing is just right. – It took exactly a year for emerging market bond investors to make back their losses from last May’s taper tantrum. After losing 12 per cent in short order when Ben Bernanke raised the prospect of ending bond buying by the US Federal Reserve he chaired, the eventual calming in long-term US rates helped bulls return to the market.
FT: – Sentiment towards emerging markets turns sour. – Institutional investors are questioning the structural emerging market story after a year of poor performance and heightened volatility.
Business Insider: – Investors are ignoring the emerging market debt warning signs. – Investors can be as greedy for yield as they can be for capital appreciation, and so far this cycle has fit that historical norm. Despite the perceived safety of income-producing securities, investors have begun to stretch for higher yields and, in doing so, seem to be taking substantial and unanticipated risks.
Salt Lake Tribune: – Long-term bonds go from outcast to on-top. – It took less than six months for some of the most feared investments to get investors to reconsider.
Barron’s: – Don’t fear risky assets. – Instruments such as high-yield and emerging-market bonds may be safer bets than many investors believe.
Seattle Times: – When investing, it pays to do the arithmetic. – Except for the very well off, everyone needs a safety net in cash, CDs or other fixed-income investment.
Market Watch: – Bond strategies for low rates and rising inflation. – Interest rates fell far this year and could stay low for some time. The world is awash with liquidity as central banks around the globe maintain highly accommodative monetary policies.
CNBC: – The retiree game plan to counter rising interest rates. – We have been talking about interest rates with our clients for years now, as historically low rates have retirees—and those who rely on income from their portfolios—yearning for yield.
TheStreet: – Bonds vs. CDs: A secure-investment showdown. – The search for safe income is not very rewarding these days — both bank rates and bond yields are at or near record lows. That makes it all the more necessary for consumers to scrounge for every point of yield they can find. One trick for choosing between deposit accounts and bonds is knowing that the right answer might vary depending on how long you are willing to lock up your money.
Reuters: – Bond ETFs swell in size and risk as institutions pile in. – Institutional investors having trouble finding bonds for their portfolios from the usual suppliers are accepting a higher degree of risk and pumping billions of dollars into exchange-traded bond funds, boosting asset management firms such as BlackRock, Pimco and State Street.
Gross: IMF says zero policy rate for longer in US is OK — “New Neutralish” forecast. 0% real.
— PIMCO (@PIMCO) June 16, 2014
LAUSD trading early in #muniland. 5s of 29 lower yield than Friday at 3.06% after last week’s pricing.
— Taylor Riggs (@TaylorRiggsMuni) June 16, 2014
Accepted # is $530 billion of unfunded OPEB retiree benefits. Most govts are paygo. Some govts could exceed pension liabilities. #muniland
— Cate Long (@cate_long) June 16, 2014