New rules put Asia at risk of credit shock
Sharp bond sell-off in recent weeks may get worse, thanks to changes in regulations
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 sell-off 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 US 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 Dhimant Shah, a fund manager at Mackenzie Investments in Singapore.
Bond markets in Asia have generally trended higher since 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 in May since the global financial crisis.
In the past month though, bonds have stumbled on jitters over when the US Federal Reserve will start to unwind its stimulus programme. Yields, which move inversely to prices, on the debt tracked by the JP Morgan basket have jumped in the past month more than 60 basis points, largely in the past two weeks. The yield on Indonesian government bonds due in 2020 has risen even faster, nearly 100 basis points in the past month.
Asia's low market liquidity could create a more explosive sell-off 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 Richard Cohen, a head of credit trading in 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 had fallen sharply as the market had sold off, although liquidity had 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 US 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, fund manager Shah 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.
The combination of factors made it more difficult for sellers, said Fredric Teng, a partner at hedge fund Oracle Capital.
"It's a bit like Tom trying to get out using Jerry's pet flap. If investors cannot get out, we could have crazy knee-jerk price actions," Teng said.