Bonds, Asia's ticking time bombs
EFFORTS to make the global financial system safer could be making Asia more - not less - vulnerable to any credit-market shocks, leaving bond traders worried that a sharp selloff since late last month could turn into a rout.
Low global interest rates have made it easier than ever to sell new bonds denominated in dollars, euros or yen, resulting in a boom in issuance that has made Asia and its companies ever more dependent on debt.
But the market for trading those bonds is slowly drying up, leaving it susceptible to a sharper sell-off if holders of these so-called G3 bonds decide it is time to head for the exit.
"The issue is that if any of them choose to sell their holdings, the market may not have the capacity to absorb these flows. If we reach a stage like that then liquidity could dry up very quickly and that can have a spiralling effect," said Mr Dhimant Shah, a fund manager at Mackenzie Investments in Singapore.
Bond markets in Asia have generally trended higher since the Lehman crisis during the global financial crisis in 2008, partly aided by the flood of cash from Western central banks aimed at reviving their economies.
By one measure, a JP Morgan basket of credit, the debt market hit its highest level last month since the global financial crisis.
In the last month, though, bonds have stumbled on jitters over when the US Federal Reserve will start to unwind its stimulus programme.
Asia's low market liquidity could create a more explosive selloff in which a lack of trading creates a price vacuum, leading to sharper price declines as investors scramble to sell assets for cash, a scenario similar to the dark days of the Lehman crisis.
"I don't recall in recent memory bonds falling so quickly without a tail-risk event as they did in the last month," said Mr Richard Cohen, head of credit trading in the Asia-Pacific for Credit Suisse. Tail-risk refers to a sudden event that has a major impact on financial markets.
Unlike equity and currency markets, there is no central repository for information on bond volumes. But dealers said volumes have fallen sharply as the market has sold off, although more generally liquidity has also been sliding in the past year as the result of some powerful factors.
Regulations under new Basel III capital requirements and the Dodd-Frank legislation in the United States are forcing Western banks to cut global operations, trim, or even eliminate, their own bond-trading operations and to cut Asian bond portfolios to reduce risk.
For example, Mr Shah, 41, left JP Morgan Chase in Singapore as head of proprietary trading last year, one of many traders who left banks as the stricter capital requirements made it tougher for them to conduct proprietary trading.
At the same time, Asian banks have not developed the expertise or the risk appetite to fill the void.
In addition, the same low interest rates that make it easy to sell new bonds are making older bonds more attractive to hold, rather than trade. The result is a diminishing amount of secondary trading in Asian bonds.
Such a squeeze could have far- reaching consequences in Asia, given its growing appetite for debt.
The region's debt-to-GDP ratio rose to 155 per cent in the middle of last year, from 133 per cent in 2008, data from McKinsey Global Institute, a unit of consulting firm McKinsey & Co, shows.
To be sure, there is no sign of widespread panic in markets.
But the sell-off is the first sign that a bull run in bonds of more than four years may be coming to an end.
There is also a flip side.
Mr Bryan Collins, a portfolio manager at Fidelity International, said that while bouts of bond-market illiquidity are a risk, they also help to remove some of the frothiness from bull markets.
And as a rise in interest rates causes a corollary fall in bond prices, some global fund houses, such as T. Rowe Price, are waiting in the wings to buy up beaten-down debt.