Bonds' Liquidity Threat Is Revealed in Derivatives Explosion
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.
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. As a lack of liquidity in Italy caused transaction costs in the world’s third-largest sovereign bond market to jump last month, Lombard Odier Asset Management helped propel an eightfold surge in Italian futures by relying more on derivatives.
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.
“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 AG.
The disparity has become more pronounced as at least two dozen nations dropped benchmark rates to 1 percent or less since the financial crisis, while the Federal Reserve, Bank of Japan and Bank of England sapped supply by purchasing trillions of dollars of debt in unprecedented stimulus programs.
It has also depressed yields and deprived traders of the volatility they need to profit from buying and selling bonds.
Yields globally have dropped by more than half in the past five years to an average 1.78 percent, while a gauge of implied yield fluctuations using options on Treasuries is now within 0.1 percentage point of an all-time low, according to index data compiled by Bank of America Corp.
At the same time, regulations designed to curb financial risk-taking such as the Volcker Rule and Basel III are limiting the flexibility banks have to facilitate trades for clients.
Dealers globally have slashed their bond inventories 75 percent since 2007. Five of the six biggest Wall Street firms reported declines in fixed-income trading revenue last quarter.
“That has to bite and prevent dealers from supplying the balance sheet they did in the old days,” Gregory Whiteley, who manages government debt at Los Angeles-based DoubleLine Capital LP, which oversees about $50 billion, said by telephone June 10. “It’s the sort of thing that rears its ugly head when it is least welcome -- when it’s the greatest problem.”
Some cracks emerged in Europe last month, when investors dumped Italian, Spanish and Greek debt on speculation political parties opposed to the European Union would gain seats in parliamentary elections and derail the euro area’s recovery.
As the selloff intensified and liquidity decreased, the disparity in yields of 10-year Italian bonds between buyers and sellers based on bids and offers doubled to 6 basis points, or 0.06 percentage point, on May 23, the highest this year.
To avoid being ensnared as transaction costs increased and trading shriveled, Lombard Odier’s Peterkin used futures contracts to wager on Italian notes rather than buying or selling the actual securities. He’s not alone.
Volume on Italian futures, which give buyers the right to purchase the nation’s debt at a future date and price, has soared more than 800 percent since trading of the contracts began in 2009, data compiled by Bloomberg show. By contrast, average daily trading in Italy’s $2.43 trillion market for government bonds, Europe’s largest, has tumbled 57 percent in the past decade, according to the Ministry of Finance.
Exchanges are seeking to capture the trend. NYSE Liffe, which was bought by Intercontinental Exchange Inc. in November, introduced new European government bond futures today including contracts for German, Italian, Spanish and Swiss debt.
“During times of uncertainty, investors may find it harder to trade large orders when they want to,” Carl Norrey, the London-based head of non-liquid European government bond trading at JPMorgan Chase & Co., said by telephone on June 12. “Some of this liquidity may be more superficial than really deep.”
Trading in Japan, the world’s second-largest bond market, has virtually ground to a halt as the central bank gobbles up about 70 percent of the interest-bearing debt sold each month. On four days last week, the benchmark 10-year note opened late.
Bank of Japan Governor Haruhiko Kuroda said in parliament last month in response to a lawmaker’s question that while he isn’t concerned that trading is drying up in the Japanese government bond market, the central bank “will continue to watch developments in the market closely to keep it stable.”
There were no trades at all on April 14, the first time that happened since 2000. Since the end of January, yields on the bonds haven’t risen above 0.654 percent or dropped below 0.561 percent -- a band of less than 0.1 percentage point.
Even in the U.S., the world’s deepest and most-liquid government debt market with more than $12 trillion outstanding, buying and selling has decreased as derivatives have surged.
For 10-year note futures, a total of 140.4 million contracts have traded in the first five months of the year, approaching last year’s total of 149.8 million, the most on a year-to-date basis going back to 2007, according to CME Group Inc. Weekly trading of Treasuries with maturities between seven years and 11 years has fallen to $96.3 billion, a 32 percent drop from a year ago, data compiled by the New York Fed show.
“This is a global phenomenon,” Yvette Klevan, a fixed-income manager at Lazard Asset Management, which oversees about $170 billion, said by telephone on June 11.
The decline in liquidity will lead to greater stability as more investors buy and hold rather than focusing on short-term trading, said John Serocold, a London-based senior director for market practice and regulatory policy at the International Capital Market Association, an industry lobbying group.
“Bonds are increasingly owned by people who are explicitly more patient,” he said. “Isn’t that what governments said they want to achieve -- more long-term investors?”
The risk of any sharp selloff may also be tempered as the European Central Bank introduced a package of stimulus measures this month and Fed Chair Janet Yellen said in May that there will be “considerable time” before the bank raises rates.
Investors still have reasons to hedge their bets. Any sudden move, such as when 10-year yields soared almost 1.5 percentage points in eight months last year, risks magnifying losses as a drop in dealer liquidity makes it harder to exit, said Andrew Richman, the West Palm Beach, Florida-based director of fixed-income at SunTrust Bank’s private-wealth management unit, which advises on more than $100 billion in assets.
Yields on just about everything -- from sovereign bonds to junk-rated company debt -- are at or close to record lows and forecasters predict they will rise as the U.S. economy regains momentum and the Fed moves to end its bond purchases.
Based on the median response in a Bloomberg survey of 75 economists and strategists, yields on 10-year notes, the benchmark for trillions of dollars of debt worldwide, will end the year at 3.07 percent from 2.6 percent at 10:09 a.m. in New York today.
“There is risk that people won’t be prepared,” Richman said by telephone June 9. “The move in yield could be quicker and more dramatic than it has in the past. That’s something we are on the lookout for.”