Bond investors remain thirsty, despite Fed liquidity efforts

US regulators have poured trillions of dollars into bond markets over the past week and eased rules on big banks to grease transactions during the coronavirus panic. Unfortunately, money can't buy liquidity.
Investors say they have been experiencing problems not just in esoteric debt instruments, but even in areas that are usually easy to trade, like 10-Year Treasury notes. The strain is being caused by regulations imposed since the 2008 financial crisis, operational issues with many trading staff working remotely, and everyone trying to sell the same things at once, industry sources said.
One result is that prices can move unpredictably, making it hard for firms to handle trades that once seemed ordinary. Mary Ann Hurley, vice president for fixed-income trading at D.A. Davidson in Seattle, said the situation can resemble a grocery store customer staring at a shelf of aging bottles of milk. "It's forcing you to buy something very close to the expiration date," she said.
Liquidity is measured by the gap between what sellers say they want to receive for securities and what buyers say they will pay - known as the bid-ask spread - as well as the size of the trades. Bid-ask spreads have gotten wider while order sizes have shrunk, several bond analysts told Reuters.
"There's not enough flow," said Jim Vogel, interest-rate strategist for FHN Financial. Lately, Vogel has found himself scrutinizing the last five or six trades to figure out where Treasury bonds are headed. Essentially investors have limited visibility in what is usually the most liquid market in the world.
"That's a form of illiquidity and part of the stay-alive mentality that we have seen across all capital markets since February 24th," he said.
THIRST NOT QUENCHED
Statistics from Quantitative Brokers, which provides traders with algorithms and analytics, show average quote sizes in 10-year Treasury futures dropping from roughly 1,500 lots - each lot is for a $100,000 contract - at the beginning of January to around 100 lots just before the US Federal Reserve announced its first set of liquidity measures in early March.
Altogether, the Fed has been offering $1 trillion each day to support overnight lending markets, has said it is purchasing at least $500 billion in Treasury securities to support market functioning and has established liquidity facilities for commercial paper markets, money-market funds and primary dealers.
The Fed has also targeted dollar-funding markets in coordination with a group of other central banks, slashed interest rates to a range of zero to 0.25% from 1.5% to 1.75%, and eased capital and liquidity rules on major banks to keep credit moving through the system.
Even with all of that, quote sizes for 10-year Treasury futures have only crept up to 175 lots per trade - far off the average from the start of the year, according to Quantitative Brokers.
Cash Treasury markets have tightened similarly, and not improved at all with the Fed's announcements, said Shankar Narayanan, the firm's head of trading research.
One fund manager said his firm often sends out lists of 100 different bonds each day to see what prices come back from dealers. It typically gets 85-90% of those requests filled at satisfactory prices, but the portion has dropped to 25% with good counterparties, and 0-15% with less reliable counterparties, said the manager, one of a few who was not authorized to speak to the press.
Financial industry trade groups have long complained that because of increased capital requirements imposed by regulators following the 2008 financial crisis, banks have chosen to carry smaller inventories of bonds, making it harder for investors to find counterparties to take their trades.
Although major dealers housed inside regulated banks like JPMorgan Chase & Co, Bank of America Corp, Citigroup Inc, Goldman Sachs Group Inc and Morgan Stanley have been able to tap emergency Fed facilities, non-bank dealers without that access have been even more cautious in filling trades, some sources said. Smaller dealers typically account for some 30-40% of bond-market activity, according to a March 10 report by JPMorgan fixed-income analysts.
The widest price differentials and most unusual volatility has been happening in corporate bonds and inflation-linked Treasury securities, said another fixed-income manager.
In some cases, corporate bonds have a bid or an offer, but not both at the same time, so trades cannot happen, he said. Operational issues are fueling problems, he said, as big portions of staff are working remotely to prevent coronavirus from spreading.