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EDHEC
26 May 2010

EDHEC risk: Radical changes in bond markets


The role of the banks is undergoing a partial shift from being an intermediary for capital allocation in the private sector to becoming more like an agent of the government, Arjuna Sittampalam argues. Also, the way of trading bonds is undergoing several radical changes affecting all participants.

Dr. Arjuna Sittampalam argues the way bonds in the western economies are bought and sold is undergoing several radical changes, affecting all participants, ranging from banks to dealers, asset managers, retail customers and the issuers, including governments.
Some of the issues explored by Dr. Arjuna Sittampalam are the followings:
Agency brokers getting squeezed?
The year 2009 was manna from heaven for fixed-income trading. Financed by loose money and government fiscal stimulus, profits from the credit rally were enhanced by relatively low liquidity and wider bid-offer spreads in corporate debt markets. Spreads have been as high as five basis points, compared with one basis point before the crisis, and were still as high as two basis points in December.
One of the reasons for wider spreads was unwillingness by banks to take risks, and even the liquid derivatives markets were affected by counterparty concerns and money market developments.
The big investment banks in 2009 had revenues heavily weighted from fixed income, currencies and commodities, and bid-offer spreads in secondary sales were a major contributor.
Where previously hedge funds were the major players and prized by bank customers, the retrenchment of the former has led to mainstream investors becoming more important. Another feature of 2009 was a turnaround in the relative importance of the cash and derivatives markets in the credit sector. The previous ratio of derivatives trading to cash of 70:30 has now reversed to 30:70. The credit derivatives market, the fount of the subprime crisis, shrunk in the twelve months to end-June 2009 from $55 trillion to $31 trillion, though $15 trillion of this change is attributable to the netting out of counterparty risk, referred to as ‘trade compression’.
Given the importance of counterparty risk, banks with stronger balance sheets have been at an advantage, and the Canadian banks, regarded as some of the world’s safest, have scored. There is now the feeling that the agency brokers who benefited from the shell shock suffered by the big investment banks in 2008 have had their day. At one point there were 70 agency brokers in the US and 30 in Europe, which captured disillusioned staff from banks.
Banks increase their role in government debt
Banks are reducing their role in society at large, or need to, because of their enforced risk aversion and higher capital requirements. On the other hand, they now hold much more government debt, as encouraged by regulations, and it looks as if they will become huge buyers of such debt on an ongoing basis. For instance, in the UK, HSBC analysts suggest that the banks will buy as much as £110bn of UK gilt issues, or 60 per cent of the total, this year. Eurozone governments are expected to issue $1.5 trillion of debt in 2010 and the US Treasury $2.4 trillion.
Conclusion
Massive changes are taking place in the world of bonds at a time when they are increasing in importance. Asset managers have to come to terms with the new dealing practices, as the relationships between them and the dealers are in evolutionary mode. It is interesting that the banks are shifting their role to supporting government bonds with the vast amount of deposit money they get from the public. In effect, the role of the banks is undergoing a partial shift from being an intermediary for capital allocation in the private sector to becoming more like an agent of the government.


© EDHEC


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