Dealers absorbing junk bonds as ETF demand drops

May 24, 2013 06:04 AM

Wall Street banks are expanding holdings of speculative-grade bonds as prices fall from record highs with investors retreating from exchange-traded funds that buy the debt.

The 21 primary dealers that do business with the Federal Reserve increased their net positions in junk-rated debt by 37% to $7.7 billion in the two weeks ended May 15, the highest since the central bank started reporting more detailed holdings data for the period ended April 3. U.S. high-yield funds reported $400 million of withdrawals last week, the second-most this year, led by $520 million pulled from ETFs, according to Bank of America Corp.

“ETFs tend to be the driver of big volume,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in a telephone interview. The job of a dealer “is to buy bonds when people want to sell,” he said.

The dealers are soaking up supply as firms from JPMorgan Chase & Co. to Barclays Plc predict demand will return. Even with banks facing new limits on risk-taking and higher capital requirements since the credit crisis, the pullback from investors is prodding them to act in their traditional roles of facilitating trading with their own money as they underwrite an unprecedented volume of new speculative-grade debt.

Prices Drop

The average price for junk bonds in the U.S. has fallen 1.06 cents to 106.2 cents on the dollar after reaching a record 107.2 on May 9, Bank of America Merrill Lynch Index data show. Shares of the biggest high-yield ETF, BlackRock Inc.’s $15.8 billion iShares iBoxx High-Yield Corporate Bond Fund, declined 1.2% to $94.89 during the period as outstanding shares in the fund dropped 2.1%, data compiled by Bloomberg show.

Speculative-grade borrowers issued $17.2 billion of new debt in the week ended May 17, the most since March 22, as they sought to take advantage of a fifth year of benchmark interest rates held at about zero, according to data compiled by Bloomberg. Junk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

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.”

‘Liquidity Mismatch’

Investors from retirees to pension plans and insurance companies are funneling cash into speculative-grade bonds, allowing companies to sell $188.8 billion of the notes in the U.S. this year, Bloomberg data show. More than 70% of the newly issued bonds are purchased by mutual funds, which are geared at individuals who may buy or sell their shares on a daily basis, according to BlueMountain’s Siderow.

That’s creating a “liquidity mismatch” because the funds buy longer-term debt, Siderow said. “Banks used to hold much greater inventory of bonds on their balance sheets and be liquidity providers to the market,” he said.

The new Fed data may not reflect the biggest banks’ capacity to facilitate trading in a sell-off, since the lenders may have significantly larger portfolios of high-yield bonds that are offset with hedges, Barclays strategists said in a May 17 report.

“When the market feels a little softer it’s a bit more likely dealers will have to provide that liquidity and expand their balance sheets,” Bradley Rogoff, head of global credit strategy at Barclays in New York, said in a telephone interview.

‘So Much Demand’

While market sentiment for high-yield bonds will eventually deteriorate, it won’t likely reverse anytime soon as central banks from the U.S. to Japan maintain bond-purchasing programs to stimulate the global economy, Youngberg said.

“There’s just so much demand for high yield it’s outstripping supply,” he said. “People think it’s painful now when they can’t buy; wait until they can’t sell.”

Elsewhere in credit markets, the cost to protect against corporate bond losses in the U.S. and Europe climbed to the highest in more than three weeks as a bigger-than-estimated increase in U.S. durable goods orders fueled concern that an expanding economy will prompt the Fed to scale back its stimulus efforts. Glencore International Plc and Vitol SA, the world’s two biggest oil traders, raised $8.3 billion in loans to fund their crude-purchase deal with OAO Rosneft.

Credit Benchmarks

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, increased 2.1 basis points to a mid-price of 75.3 basis points as of 10:01 a.m. in New York, the highest since May 1, according to prices compiled by Bloomberg. The index has climbed 5 basis points this week, poised for the biggest weekly jump since the period ended March 22.

In London, the Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, rose 5.6 to 98.2 and is up 7 on the week.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.45 basis point to 15.5 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Petrobras Bonds

Bonds of Petroleo Brasileiro SA are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 7.1% of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Petrobras, as the Brazilian state-run oil producer is known, sold $11 billion of bonds abroad last week, the most ever for an emerging-market issuer.

Glencore and Vitol’s five-year loan increased from $7.5 billion after 10 to 15 lenders joined the facility, according to three people with knowledge of the matter, who asked not to be identified because the terms are private. Further banks have the option to commit to the deal, which can be increased to as much as $10 billion.

Specially-created companies are raising the prepayment loan, which will be backed by a portion of future oil production of Moscow-based Rosneft, Bloomberg data show. Russia’s largest oil company signed contracts and will receive a prepayment of as much as $10 billion for 67 million tonnes of crude, according to a March 6 statement.

The loan pays interest at 210 basis points, or 2.1 percentage points, more than the London interbank offered rate, Bloomberg data show.

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