Dominick Reuter/ReutersComments by Ben S. Bernanke, the Federal Reserve chairman, contributed to a sell-off in bonds in recent weeks. But the turning point in the markets barely dented bank earnings.There may be less reason to fear the big, bad bond market.
With $38 trillion of bonds outstanding, any large and negative moves in bond prices have the potential to damage the wider financial system.
This occurred during the financial crisis of 2008, when mortgage-backed bonds plunged in value. It also happened during the European debt crisis, when losses piled up on sovereign bonds. Banks that held large amounts of such bonds suffered huge hits to their balance sheets, and bailouts became necessary.
So how is the financial system faring after the turbulence that swept through the bond market? Pretty well, judging by the latest financial results from Wall Street banks.
In the last few days, the three big American bond-trading firms — JPMorgan Chase, Citigroup and Goldman Sachs — all reported second-quarter financial results that were helped by healthy bond trading revenue.
That’s somewhat remarkable considering the amount of pain in the bond market during the quarter. The selling started in early May, and became particularly intense after Ben S. Bernanke, the Federal Reserve chairman, said the central bank might pare back the enormous bond-buying programs it has undertaken to support the economy.
This turning point in the markets barely dented the banks. In the second quarter, Citigroup reported revenue of $3.4 billion in its fixed-income division, which trades bonds, currencies and commodities, as well as derivatives linked to those assets. Citi’s revenue was 18 percent up on the same quarter in the previous year. Over the same period, JPMorgan’s fixed-income revenue rose by 17 percent, and Goldman’s climbed 12 percent.
One reason the banks fared relatively well is that, despite the sharp fall in bond prices, their customers didn’t withdraw en masse from the market. That occurred in the second quarter of last year during a swoon in European markets. Wall Street firms posted weak fixed-income results for that period.
Regulation may have helped in shielding the wider system from bond market stress. Banks hold large stockpiles of bonds, partly to service client demand and partly to generate trading income. However, since the financial crisis, new rules have made it less comfortable for banks to hold huge inventories, causing them to shrink drastically.
Currently, Wall Street dealers hold nearly $60 billion of corporate bonds, mortgage-backed bonds and short-term debt called commercial paper, according to data from the Federal Reserve Bank of New York. In 2007, those inventories peaked at $235 billion.
Put bluntly, banks have less stuff to take losses on these days. When the market value of the bonds in these inventories decline, Wall Street entities have to book losses to reflect that the holdings are worth less. This tends to be the source of the most punishing losses during bond market shakeouts. But with smaller inventories, banks stand to suffer far less pain.
Skeptics of the new rules say that one danger of shrinking bond inventories is that banks have less capacity to acquire bonds from sellers when bond markets are weak. In turn, they say, this can contribute to violent price swings when investors turn against bonds. The steep declines in bond prices in the last month may have something to do with this.
But it appears that prices moved lower in a relatively orderly fashion. This can be seen in a measure of the bid-offer spread, which is the difference between the price at which banks buy bonds and then sell them to investors.
The bid-offer spread typically increases substantially in times of stress. But during the latest upheaval, the increase was slight. The spread right now is 0.11 of a percentage point on highly rated corporate bonds, according to an index from MarketAxess, a firm that runs a bond-trading platform and conducts bond market research.
That’s wider than the recent low of 0.075 of a percentage point. But it is still well below the 0.35 of percentage point at the end of 2008. In other words, the market held together even though banks had historically low bond inventories.
But it might be a mistake to assume all is well. First, while regulations appear to have shielded Wall Street from crippling bond losses in recent weeks, they have shown up elsewhere in the system, like the investment funds that hold bonds. Those losses create real financial pain for real people. However, such losses are less likely to be destabilizing to the system.
Mutual funds and similar investment vehicles aren’t acquiring their bonds using large amounts of borrowed money, or leverage, to boost returns. That’s an important distinction. In the past, it’s been leverage that has magnified bond losses and made them crippling to the system.
Wall Street firms do, however, use large amounts of leverage. And that is why regulators introduced new rules to make their fixed-income businesses safer.
Things could still go wrong, though.Some analysts believe that the most recent downturn shouldn’t be seen as the decisive test for the post-crisis bond market. When the Federal Reserve actually does stop buying bonds, the convulsions could be far greater than those seen in the last month.
“When tapering kicks in, the market will look very different to this,” Will Rhode, a principal of Tabb Group, a firm that analyzes market infrastructure, said. “You ain’t seen nothing yet.”