In today's bond market, there's plenty of hand-wringing about liquidity, or rather, the lack of it.
It's become so pervasive that even in the market for U.S. Treasuries—the deepest and most liquid on the planet—buyers are gravitating to the newest, easiest-to-sell debt. This year, investors are paying almost twice the average premium to own the most recently auctioned 10-year notes, known as "on-the-run" securities, instead of "off-the-run" ones issued just a few months earlier, data compiled by Barclays Plc show.
Part of it can be explained by the turmoil in financial markets, which has boosted demand for haven assets. At the same time, selling by emerging-market central banks, which typically own older Treasuries, to shore up their economies has also widened the gap in prices.
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Yet beyond those issues lie deeper concerns about the very structure of the U.S. bond market, and whether post-crisis rules intended to prevent another financial catastrophe have ultimately left it broken. The signs of strain have even caught the attention of the Treasury Department, which this month called on market participants to provide suggestions for fixes.
"We've been seeing erratic behavior overall in debt markets," said Michael Cloherty, the head of U.S. interest-rate strategy at RBC Capital Markets LLC, one of 22 primary dealers required to bid at U.S. debt auctions. "That includes dislocations in Treasury off-the-run securities. This is all related to liquidity issues" as regulations cause banks to pull back from trading.
Since the start of the year, buyers of on-the-run 10-year Treasuries are, on average, paying a 0.022 percentage point premium relative to off-the-run notes, based on yields relative to Barclays' spline fair-value pricing model.
In the previous five years, the annual average premium was 0.0126 percentage point. As recently as 2014, it amounted to less than 0.01 percentage point, the data show. Yields on the benchmark 10-year note were at about 2.03 percent today.
Bond investors are sacrificing returns to own the most-liquid Treasuries because trading large blocks at a moment's notice without causing prices to move has gotten harder and harder. Based on Bloomberg's U.S. Government SecuritieInves Liquidity Index, conditions have deteriorated significantly over the past two years.
The issue of liquidity, and how it can exacerbate price swings as more and more trading happens electronically, has become increasingly important since Oct. 15, 2014. That's when, for no apparent reason, yields suddenly plunged before rebounding just as quickly in what became one of the most volatile trading days in a quarter century.
Why Investors Favor On-the-Run Securities
While Treasury officials including Secretary Jacob J. Lew have said regulations didn't play a significant role in what happened that day, the concern is that many of those same rules are responsible for the distortions that have emerged in the U.S. bond market.
"The backdrop to all this is that you have dealer balance-sheet constraints and risk aversion—both of which are leading to an increase in premium for more liquid securities," said Anshul Pradhan, a New York-based debt strategist at Barclays.
Echoing comments made by executives at the biggest financial firms, Pradhan says that rules implemented after the 2008 financial crisis, such as Dodd-Frank and Basel III, have made it costly for bond dealers to maintain large inventories of Treasuries on their balance sheets. In Basel's so-called supplementary leverage ratio requirement, government bonds are considered just as risky as corporate debt.
With dealers warehousing fewer bonds, trading of older Treasuries has gotten even harder and caused investors to favor on-the-run securities.
"It's all about the cost of balance sheet," said Ward McCarthy, the chief financial economist at Jefferies Group LLC. "This makes it more expensive for anybody to be involved in the Treasury market in anything besides the active securities. That makes it more difficult and probably more costly for investors to manage portfolios."
It has gotten to a point where the Treasury, in its quarterly dealer survey on Jan. 15, asked for feedback on "liquidity conditions for off-the-run Treasuries" and "what steps the Treasury should consider if you believe that liquidity in off-the-runs has diminished."
Last week, the Treasury also asked industry participants for input on how the market has changed and what should be done to operate it more smoothly.
Isaac Chang, the head of KCG Holdings Inc.'s client Treasury market-making business, says separately that making trading data more accessible would bring in more players and help reduce the price disparities of on-the-run and off-the-run securities.
"There is a clear supply-demand imbalance that has led to this cheapening of off-the-runs versus on-the-runs," he said. "These conditions are exacerbated by the current market structure."
Raising Cash as Global Markets Falter
With global markets buckling, things aren't likely to get better anytime soon as investors seek shelter in the easiest-to-buy Treasuries. Global equities are off to one of their worst starts on record, with Chinese and European stocks falling into bear markets. Oil's slump to about $30 a barrel, from more than $100 just two years ago, is also deepening concern that the world economy is faltering.
Compounding the problem is the fact that the fallout has prompted many developing-nation central banks to sell Treasuries for needed cash as they try to prop up their economies and currencies.
China, which has more than quadrupled its stockpile of Treasuries to $1.4 trillion over the past decade, has led the way as it sought to ease capital flight amid the weakest growth since 1990. The country burned through a half-trillion dollars of foreign-currency reserves in the past year, much of it by selling U.S. government debt.
"You have the world's largest central banks reducing their reserves," said Subadra Rajappa, the head of U.S. rates strategy at Societe Generale SA. "That is definitely putting pressure on off-the-runs."
–With assistance from Robert Gee.
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