Analysis: For all the debt, there's a shortage of bonds

LONDON Wed May 15, 2013 1:58am EDT

The U.S. flag hangs outside the New York Stock Exchange November 9, 2011. REUTERS/Brendan McDermid

The U.S. flag hangs outside the New York Stock Exchange November 9, 2011.

Credit: Reuters/Brendan McDermid

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LONDON (Reuters) - Debt may be everywhere but there's a scarcity of bonds.

With governments awash with debt and furiously selling new securities to fund bloated budget deficits, the idea of a bond shortage on the marketplace may sound puzzling.

Yet not only is "quantitative easing" by the world's major central banks sucking benchmark bonds out of the system, new regulations to strengthen banks and derivatives markets that effectively ring-fence bond holdings at commercial banks has raised concerns about a lack of bonds to lubricate the system.

And while Federal Reserve Chairman Ben Bernanke claims to be monitoring any sign of a reckless "reaching for yield" among investors as government and corporate borrowing costs sink around the globe, the skew in supply and demand for bonds speaks volumes.

JPMorgan estimates that the world's central banks and commercial banks alone now hold some $24 trillion worth of bonds - or 55 percent of the entire $44 trillion universe of government, asset-backed and corporate bonds as captured by Barclays Multiverse Global Bond Index.

What's more, these players hold more than two thirds of the government bond subset, which amounts to about $25 trillion.

"That's why we are in such a depressed bond yield environment," said JPMorgan economist Nikolaos Panigirtzoglou.

Cumulative bond buying since 2008 by four major central banks alone - the Fed, Bank of Japan, European Central Bank and Bank of England - reached more than $4 trillion this year. Added to existing holdings, that brings their total to $5.2 trillion.

With new Fed purchases of Treasury bonds set to top $1 trillion in 2013 and Bank of Japan bond buying more than half that amount, the year-end total will be about $6.5 trillion.

And as both the Fed's and the Bank of Japan's bond buying will exceed new bond sales by their governments by at least $100 billion this year, there will be fewer bonds around this year than last despite all the new debt sales.

Add to that $8.7 trillion of bonds estimated to be held by central banks in China and around the globe to bank their hard cash reserves, and $10 trillion of bonds held by commercial banks in the G4 developed economies to hold down risk-weightings on their assets - then there's not much left for everyone else.

With banks viewing Treasury bonds as a direct substitute for cash or "excess reserves" with slightly higher returns, the remaining bonds in the banking system get passed around like "hot potatoes" and yields converge, said Panigirtzoglou.

The central point of JPMorgan's number crunch was to show the remaining $20 trillion of the bond universe, held by non-banks such as pension, insurance, mutual and hedge funds, means the investment world is unlikely to be as overweight bonds as many had assumed. That total, they reckon, would only amount to about 30 percent of their combined bond and equity holdings.

And this tallies with asset managers, who are already eschewing what they consider to be scarce and over-expensive government debt in favor of often higher-yielding if lower quality corporate and emerging market bonds.

"Bizarrely, despite all this debt issuance there is a shortage of bonds," said Alan Higgins, Chief Investment Officer at British private bank Coutts, adding there were plenty of signs of what he called "leakage" within the more conservative fixed income funds to higher-risk securities as a result.

BOND DROUGHT?

What's more, this bond drought on the investment markets has added to growing concern about a shortage of high quality collateral - typically top-rated bonds - pledged and repledged within the financial system to raise cash.

For example, the latest meeting of the U.S. Treasury and bond market participants - the quarterly Treasury Borrowing Advisory Committee - discussed the problem late last month.

It concluded that with AAA- and AA-rated sovereign borrowers selling an estimated $2 trillion of new bonds annually, supply of this high-quality collateral would probably be two to three times demand in normal conditions. However, it said demand could well approach $10 trillion in "stressed markets".

This concern about having enough collateral available to generate credit within the financial system refocuses on a central aspect of the banking crisis and its aftermath.

International Monetary Fund economist Manmohan Singh has in a number of papers over the past year estimated that interbank mistrust and banks' narrowing definition of acceptable collateral reduced the re-use or re-pledging rate by the big banks to about 2.4 times from 3.0 before the crisis, involving a drop of up to $5 trillion in the cash generated by the banks.

That's more than the cash injected by the central banks' bond-buying programs since 2008 and for many this reduced "velocity" of cash-like collateral within the system helps explain why credit in the economy at large is still stalled.

For Singh, it's the rise in ‘idle' or 'silo-ed' collateral due to institutional ring-fencing - QE, new bank capital and derivatives markets regulation and central bank reserve management and the like - that policymakers now need to watch closely.

(Editing by Ruth Pitchford)

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