Dealers absorbing junk bonds as ETF demand drops

Dealer Reversal

The expanding junk debt on bank balance sheets marks a reversal from April, when they cut net holdings by 24% to $5.63 billion, Fed data show. Banks have been reducing inventories amid global banking regulations that make riskier securities more expensive to own and the so-called Volcker rule in the U.S. that limits how much risk a lender can take with its own money.

“The increasing regulation of the banking sector is causing bank-balance sheets to shrink,” Stephen Siderow, president and co-founder of BlueMountain Capital Management LLC, a credit-focused hedge-fund firm, said May 21 at the Bloomberg Link Canada Economic Summit in Toronto. “As a result, more capital is flowing from savers’ hands to borrowers’ hands through alternative means.”

Primary dealers reduced their corporate-debt inventories by 76% since peaking in October 2007 at $235 billion to $56 billion as of March 27, when the Fed revamped the way it calculates and reports their holdings. Prior to April 3, the central bank didn’t break down the data into ratings categories and it included some mortgage-related debt.

Expanded Market

Dealer junk-bond holdings had fallen to as low as $5.63 billion on May 1, down $1.8 billion from April 3, Fed data show.

The firms’ net holdings, which cancel out positions in which banks take opposite bets on the direction of a security’s value, account for about 0.7% of the dollar-denominated junk-debt market, which has swelled to include $1.1 trillion of notes, according to Fed and Bank of America Merrill Lynch index data.

The dealers have increased their investment-grade bond holdings by 11% this month, to $13.1 billion on May 15, Fed data released yesterday show. BlackRock’s $23.4 billion ETF that focuses on those notes reported about $336 million of withdrawals in the week ended May 15, according to data compiled by Bloomberg.

Trading volumes have been rising, with the average daily amount of investment-grade bonds traded 14.5% higher during April and May compared with the same period last year, JPMorgan strategists led by Eric Beinstein in New York said in a report today.

Junk Gains

The reason is likely a combination of a “more positive market environment generally where investors and dealers are more comfortable trading actively as they did pre-crisis,” as well as the effect of Fed stimulus, the analysts said.

High-yield bonds have posted average annualized gains of 21% since 2008 after the Fed pumped more than $2.5 trillion into the financial system to spur economic growth. Yields on dollar-denominated junk bonds plunged to an unprecedented 5.98% on May 9, down from 19.5% at the end of 2008.

Even with dealers taking on more of the debt, the overall plunge in inventories has lengthened the time it takes to buy and sell bonds as demand outstrips supply, according to Todd Youngberg, head of global high-yield fixed-income at Aviva Investors in Chicago.

“You trade in much smaller bite sizes these days,” he said in a telephone interview. “Liquidity suffers a little bit as a result of that.”

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