CEOs are worried about bond liquidity. Should you be?

Prudential Investment Management Chief Executive Officer David Hunt says the No. 1 concern among bond buyers globally is liquidity and its rapid disappearance.
“The biggest worry of the buy side around the world is that there has been a dramatic decline in liquidity from the sell side for many fixed income products,” said Mr. Hunt, who heads Prudential Financial Inc.’s investment management unit, which had $934 billion in assets at the end of 2014. “I think it’s a big risk and is one of the unintended consequences” of regulators trying to prevent another financial crisis, he said.
While the size of the U.S. bond market has swelled 23% since the end of 2007 through the end of last year, trading has fallen 28% in the period, Securities Industry & Financial Markets Association data show, as regulators, seeking to reduce risk, have made it less attractive for banks to hold an inventory of tradable bonds. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon warned in a report last week the next financial crisis could be exacerbated by a shortage of U.S. Treasuries.

“If we had a major political event or something that caused rates to spike and traders needed to get out of the current position they have, and there was a lot of people that wanted to do that, I think it would be quite difficult,” Mr. Hunt, in Tokyo last week for various management meetings, said. He declined to comment on what measures Prudential is taking to lower liquidity risk, saying that information was sensitive from a competitive perspective.
DIMON LETTER
The liquidity drain in bond markets spans Treasuries to corporate notes, Mr. Dimon said in a letter to shareholders dated April 8. “Liquidity can be even more important in a stressed time because investors need to sell quickly, and without liquidity, prices can gap, fear can grow and illiquidity can quickly spread,” he wrote. “The likely explanation for the lower depth in almost all bond markets is that inventories of market-makers’ positions are dramatically lower than in the past.”
Inventories are lower, Mr. Dimon said, because of multiple new rules that affect market making, including “far higher” capital requirements. The total inventory of Treasuries readily available to market makers today is $1.7 trillion, according to JPMorgan, down from $2.7 trillion at its peak in 2007.
Erik Schiller, a money manager for Prudential’s more than $500 billion fixed-income unit, said that he’s been using futures more because they offer fast and anonymous trade execution during big market swings.
BANK STIMULUS
One measure of Treasury dealers’ trading activity has fallen closer to its financial-crisis levels. Deutsche Bank AG’s index that gauges liquidity by comparing the three-month average size of dealer trades against moves in the 10-year note’s yield declined to about 25 in February. It was above 500 in 2005, and reached as low as 19 in 2009 during the depths of the financial crisis.
Federal Reserve Bank of New York Executive Vice President Simon Potter said Monday in New York that new bank rules and automated trading could be sapping U.S. Treasury market liquidity and may spur more volatility.
Although lower commodity prices and productivity gains are spurring economic growth in many parts of Europe, central bank stimulus globally has created fragility that over time will lead to more volatility in markets, Mr. Hunt said in the April 10 interview. “We’ve started to see more very cursory underwriting that is happening in the market and that does concern us,” he said.
Mr. Hunt, who joined Newark, N.J.-based Prudential Investment as CEO in November 2011 from McKinsey & Co., said “without a doubt” the firm’s “favorite move at the moment is in the U.S. corporate credit market.” Interest rates in the U.S. will probably remain low for some time even with a probable rate increase by the Fed in the second half, he said.
“They’ll move a little bit and then they are going to wait and watch and they may not move again for a bit, so we are again quite sanguine,” Mr. Hunt said. “I think they don’t want to move too quickly and bring on any kind of recessionary force.”
Slowing growth in China will help keep inflation down and disappoint some who are betting on increased demand from the world’s second-biggest economy based on past data, Hunt said.
“There is serious overcapacity driven by building for a China that is probably not going to quite come into fruition,” Mr. Hunt said. “There’s overcapacity in a lot of the world’s industries that will be laid bare by these lower rates.”
PIMCO EMOTIONS
Prudential is more optimistic than many about recovery prospects in Japan and Europe and is overweight equities from those areas. Prudential also likes high-yield bonds in the U.S. not tied to the energy sector, he said.
Assets at Prudential’s fixed-income business rose to $543 billion at the end of December, up from $418 billion in March in 2014, the company’s website shows. Following the surprise exit of co-founder Bill Gross from Newport Beach, Calif.-based Pacific Investment Management Co. last year, the Pimco Total Return Fund alone suffered more than $100 billion in redemptions. Pimco’s troubles left him with mixed emotions, Mr. Hunt said.
“It is never a good thing, when I would say, a deeply respected firm and a firm that had done extremely well by its clients for many, many years comes a bit unstuck,” he said. “That said, there has been a lot of money that has moved and I do feel quite good that we’ve gotten our fair share of that money that has come out. But I would say that we are also happy to see that the firm seems to have stabilized and we wish them well.”