When the Federal Reserve examines the trading books of the world’s largest banks, regulators may find surprisingly little exposure to one risky market: junk bonds.

Wall Street’s biggest debt dealers have been dumping speculative-grade securities at the fastest pace on record ahead of annual stress tests by the Fed. They reduced their holdings by 68 percent in the week ended Oct. 15, as the market posted losses of 1.5 percent that week alone, according to data released by the Fed last week.

It makes sense for banks to scale back risk tied to speculative-grade credit since regulators are going to focus on the debt in testing “for significant spread widening, particularly of less-liquid securities,” said Charles Peabody, a banking analyst at research firm Portales Partners LLC in New York. “The odds are you’re going to see the downside of the credit cycle in the next year or so.”

Banks have been cleaning up their balance sheets in preparation for the latest round of exams by regulators seeking to prevent a repeat of the financial crisis that led to the collapse of Lehman Brothers Holdings Inc.

“We believe that dealer risk appetite is likely to have been low recently because of the snapshot of large bank trading books ahead of the Fed’s upcoming stress tests,” Bank of America Corp. analysts Priya Misra and Shyam Rajan wrote in an Oct. 15 report. “This may have exacerbated price action.”

U.S. junk bonds tumbled 2.1 percent in September, their worst month since June 2013, according to Bank of America Merrill Lynch index data.

The Fed is homing in on speculative-grade corporate debt in particular because such bonds and loans tend to suffer disproportionately in times of stress.

Under a worst-case scenario being simulated in the latest round of Fed stress tests, “U.S. corporate credit quality deteriorates sharply,” according to an Oct. 23 Fed report. Relative yields on high-yield bonds and loans would “widen to levels the same as the peaks reached in the 2007–2009 recession.”

At 4.38 percentage points, the extra yield investors currently demand to own junk bonds instead of government debt is just a fifth the 21.8-percentage-point spread reached in December 2008, according to Bank of America Merrill Lynch index data.

While default rates are still about half their historic averages, concern is mounting that more companies will struggle to make their debt payments as the Fed prepares to raise borrowing costs. Policy makers have kept their benchmark interest rate near zero for almost six years.

 

Cutting Risk

The Fed and the Office of the Comptroller of the Currency have been heightening their scrutiny of leveraged lending, too, leading the biggest banks to back away from funding some takeovers financed by the debt. They’ve warned banks that rising levels of such risky loans on their balance sheets may require more capital held against them, a person familiar with the conversations said last month.

The data suggest these warnings haven’t gone unheeded.

The 22 primary dealers that trade with the Fed pared their high-yield bonds to a net $2 billion dollars on Oct. 15 from $6.26 billion the week before, the Fed’s figures show. The dealers held about $8 billion of the notes as recently as Sept. 24.

“Between the volatility, the inflection point in the credit cycle, illiquidity in managing inventory, it makes sense you’d want to reduce your risk,” Portales’s Peabody said.

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