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Demand for bonds is so strong, there's not enough to trade
[LONDON] Global debt has never been higher yet the amount of bonds available to trade is shrinking rapidly, potentially threatening the functioning of major bond markets.
Regulatory changes curbing investment banks' ability to act as lynchpins in bond markets and a surge in demand from central banks and "buy and hold" investors like pension and insurance funds means fewer and fewer bonds are actually changing hands.
According to Nikolaos Panigirtzoglou at JP Morgan, the world's central banks and commercial banks alone now hold some US$27 trillion worth of bonds - or half of the entire US$54 trillion universe of government, asset-backed and corporate bonds as captured by Barclays Multiverse Global Bond Index.
What's more, these players hold around two thirds of the government bond subset, about US$34 trillion.
With banks holding bonds for regulatory purposes, pension funds holding them to match assets and liabilities, insurance funds buying them for solvency reasons and central banks for policy goals, huge chunks of the fixed income universe are in the hands of players who are unnatural sellers.
Cumulative bond buying since 2008 by four major central banks alone - the Federal Reserve, Bank of Japan, European Central Bank and Bank of England - reached more than US$8.6 trillion this year. Added to existing holdings, that brings their total to US$9.6 trillion.
Germany's central bank is on course to own around 25 per cent of the German government bond market by the end of this year, according to HSBC. Analysis from ING shows that the Fed owns over 20 per cent of the US Treasury market, the BoE owns 30 per cent of the UK gilt market and the BOJ owns 40 per cent of the Japanese Government Bond market.
Pension funds are upping their exposure to bonds too, and central bank demand is rising. The Bank of England has even failed to find enough willing sellers at some of its auctions.
Data from Germany's debt management agency shows that the "turnover rate" in German government debt, a gauge of buying and selling activity in the secondary market as a proportion of total debt outstanding, has halved over the last decade.
And it's not just sovereign bond markets. The amount of bonds changing hands on secondary European corporate debt markets relative to new issuance is plummeting too.
"There are numerous signs that the Bund market is not a particularly well-functioning market," said Bert Lourenco, rates strategist at HSBC.
"You can't really say the market is mispriced as driving yields to exceedingly low levels has been an intentional feature, as in the case of Bunds. But market pricing right now is heavily dependent on central bank policies," he said.
One such sign is the decline in bonds available for banks and other market makers to use as collateral for repurchase agreements between financial institutions. "Repos" are effectively short-term loans between institutions, often overnight loans, and are critical to the functioning of the bond market and wider financial system. Repo rates are usually anchored close to central bank policy or deposit rates, which in the eurozone are 0 and -0.4 per cent, respectively.
But HSBC's Mr Lourenco says bonds have been so scarce in certain pockets of the market that repo rates have fallen as low as -100 basis points, signifying a severe shortage of bonds for repo collateral.
According to Germany's finance agency, the turnover rate in German debt fell to 4.4 last year, the lowest since comparable records began in 2005, when it stood at 8.8.
Overall trading volume in German sovereign debt hit a low of 4.704 trillion euros last year. That's even lower than 2009 when markets seized up following the global financial crisis and marks a steep decline from over 7 trillion euros in 2005, the Finanzagentur said.
It's not just sovereign bond markets. Figures from market data and post-trade service provider Trax, a subsidiary of bond trading platform MarketAxess, show that secondary euro- and sterling-denominated corporate bond market trading as a share of new issuance is shrinking rapidly.
Volume was 642 billion euros in the first seven months of this year, or 69 per cent of total issuance over the period. That compares with 99 per cent a year ago and 115 percent in 2014.
In sterling markets trading volume over the same period was 61 per cent of total issuance, down from 224 per cent last year and 268 per cent the year before that.
This is partly due to pension funds buying up increasing quantities of corporate bonds as they seek to match their long-term liabilities with assets of similar duration and get a return over and above record low government bond yields.
UK pension funds' allocation to bonds has risen to a record high 48 per cent this year, up from 31 per cent in 2003, according to consultancy firm Mercer, while their equities allocation has fallen to a record low 31 per cent from 68 per cent.
Despite the record low yields, funds intend to increase their bond holdings further in the year ahead, Mercer said. "This is leading to reduced market liquidity. This is structural. This is a fact you have to live with," said Prashant Sharma, head of International Fixed Income Insurance at JP Morgan Asset Management in London.
"Prices ebb and flow, but there has been a notable decrease in liquidity. It means investors are more likely to buy and maintain, and less likely to be tactical," he said.