The big threat to bonds

Tighter rules governing banks’ bond holdings and debt-market activities could cause the next credit crunch.

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The middlemen have been squeezed out

"The policy and regulatory response to the last crisis often sows the seeds for the next," says Ben Wright in The Daily Telegraph. Hence investors are now starting to fret that tighter rules governing banks' bond holdings and debt-market activities could "come back to haunt us", as Investec Asset Management's John Stopford puts it and even help cause the next credit-crunch-style meltdown.

The growing fears concern liquidity, or the ease with which sellers can find buyers. Banks used to act as market makers in the bond market, meaning that they were middlemen for investors buying and selling. But now they are less keen to play that role, due to new rules that make it much more expensive for them to hold bonds in inventory.

This means that there is now a much greater danger of a liquidity crunch. That raises the risk of sudden lurches in price, and resulting damage to investors' portfolios, if there is a rush to the exit in the debt markets which might be caused by a rapid shift in expectations about interest-rate rises, for instance.

"There is less oil in the system," as one bond manager says in the FT. "If everyone wants to redeem at once, there could be a liquidity crunch because, without the banks, there won't be anyone bidding for the bonds."

The unprecedented "flash crash" in ten-year US Treasury yields in October a plunge from 2.2% to 1.9% and a snapback all within 15 minutes was blamed on a dearth of liquidity. That rattled observers, because US Treasuries are supposed to be the most liquid market in the world.

But the real concern is the corporate debt market, overpriced and flooded with new issues. European and British non-financial companies sold over $400bn (£269bn) of debt last year. In 2005, they issued £156bn. Yet the Royal Bank of Scotland reckons that there has been a 90% drop in liquidity in the US credit markets since 2006.

If a selling stampede occurs, it's easy to imagine yields rocketing as prices tumble, squeezing companies' accessto finance and tearing new holes in financial institutions' balance sheets.

This time round not only does the liquidity crunch threaten to make the sell-off even more violent, but the losses would be concentrated among fewer big investors in bond markets. And European banks in particular will still be vulnerable. They are so highly geared, says Wright, that "if their holdings turn out to be worth just 3.7% less that was assumed, it will be time to order in the pizzas for late-night discussions about bailouts".

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