Bond liquidity: risk and return

Consider the disaster scenario: regulations aimed at reducing risk-taking at banks make it impossible or unprofitable for them to hold large inventories of bonds (dealers' holdings of corporate and other non-Treasury debt have already dropped by four-fifths from the pre-crisis peak). Then the bond market slumps.

Low inventories have not been a problem to date, with interest rates near zero, companies flooding the market with new issuance, and voracious investor demand (half a trillion dollars has flowed into corporate bond funds since the crisis). But in a nasty sell-off, without Wall Street middlemen greasing the wheels, prices fall sharply as sellers clog the exits. The resulting spike in yields and drop in liquidity will make it much harder and more expensive for companies to borrow - crippling the economy.

So, at any rate, some banks and bond managers would have you believe. As well they might. Both bond buyers and bond dealers profit from a leveraged and liquid bond market. In the bond business, less risk on banks' balance sheet would mean less profit on the P&L (at the same time as electronic trading is threatening to disintermediate banks' bond desks). Fund managers worried about liquidity will have to hold a lower-duration, lower-risk, lower-yielding portfolio. In other words: efforts to reduce risk may - surprise! - have the effect of reducing risk.

Torrents of money have chased yields on corporate bonds to historic lows, and corporate borrowing (as measured, for example, as a per cent of domestic output) is near historic highs. A tap on the brakes would not be all bad. It is legitimate to worry that changing market structures will have unforeseen effects, especially when the market appears poised for a reversal. But it is not helpful to point out that risk and return are related - which is what some of the criticisms of reform amount to.

Email the Lex team in confidence at [email protected]

© The Financial Times Limited 2013. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation