Salomon Brothers has a near mythical place in Wall Street history as the premiere bond trading shop of its time. That’s why it’s hard to imagine, many years after being absorbed into and digested by the unmanageable blob known as Citigroup, that its legacy is being even more thoroughly erased by market changes and Citi’s own policies.
Four banks, along with Citi, failed the Fed’s stress tests in March but none play as big a role in the corporate bond market as Citi does. Further pressure on the megabank to cut back on its assets won’t help a market where dealer inventories have fallen by nearly 85 percent in recent years. The stress test woes of HSBC, RBS Citizens, Santander and Zions will not affect the market, but Citi’s pain will inevitably depress its appetite for holding inventory.
The problems are not only in the US For the last few weeks, European banks have been scrambling to prepare for the European Central Bank’s upcoming stress test. It will use data on some 160,000 loans being currently reviewed scrutinized for its current Asset Quality Review, which was finished in late July, to provide input for its own stress tests. With many European banks exposed to weak economies and markets, the stress tests could find that many are undercapitalized. They are due to be published in October, and banks will have just two weeks to fix any shortcomings the ECB discovers.
To remain competitive and service their increasingly agitated buy side and corporate treasury clients, 10 dealers and Thomson TradeWeb are planning to launch a new bond trading platform later this summer. People familiar with the matter have told the Financial Times and Wall Street Journal that the goal is to increase liquidity.
It’s debatable that it will succeed. First, there have already been a handful of these initiatives, mostly around the dotcom era, and none of them successfully disintermediated the interdealer brokers, as intended.
Also, dealers are not only capital constrained from warehousing gobs of corporate bonds. They are also looking at a market characterized by super-low interest rates. With the end of quantitative easing coming up in October, any inventory they hold could be subject to non-trivial losses. And given the abysmal performance of fixed income, currency and commodity departments over the past 18 months, dealers are justifiably wary of taking any further hits to their P&Ls.
So the situation isn’t really amenable to a technical solution. It’s not that dealers can’t trade already, it’s that they just don’t want to.
Most of the decline in dealer inventories has been snapped up by open ended mutual funds – those that offer daily liquidity. These funds now hold some $840 billion in corporate bonds, according to Reuters. Should there be a run on these funds, the dealers’ unwillingness to provide liquidity would put the asset managers in a pickle. This is the nightmare scenario that Securities and Exchange Commission regulators have been worrying about in the money fund sector.
Asset managers have responded by cooking up their own trading platforms but they have not been effective. Even bond giant BlackRock sold its trading platform after it failed to attract enough business.
So far, the lack of dealer willingness to warehouse bonds hasn’t affected the primary market. That’s mainly because of the appetite from mutual funds. But some funds have started to see withdrawals – even Pimco boss Bill Gross’s flagship is oozing AUM. (Although that might be more of a result of his odd behavior leading up to Mohamed El Erian’s departure.)
The main fallout from all of this will be on the buy side. But if dealers cannot find a way to support the market without hitting capital hurdles and risk management red flags, corporate issuers could see borrowing costs rise sharply.