The third annual report from the Office of Financial Research, a newly created division of the Treasury Department as a result of the 2010 Dodd-Frank Law, warned that bond markets are vulnerable to more shocks due to new regulations that have changed trading patterns. (For the full report, click here.)
According to the Office of Financial Research's report, "Markets have become more brittle because liquidity may be less available in a downturn. Recent volatility in financial markets focused attention on some of the vulnerabilities that have been growing over the past several years."
The Office expressed concern that market participants such as banks and securities dealers may be less willing to enter the markets during periods of dislocation to facilitate trading that can smooth volatility, an important role these institutions have played in the past. In order to meet the requirements of Dodd Frank, banks have had to increase their capital and curtail risk-taking activities. As a result, many financial institutions over the last several years have significantly reduced personnel and capital allocations for their bond trading departments. While banks and securities dealers are now more insulated from certain market risks, these risks have shifted to investors.
In addition, the report noted that high-volume trading driven by algorithms and automatic computer programs can deepen volatility and potential market instability. In other words, risk today is more likely to be tilted toward institutional and individual investors and away from banks and dealers.
An Unknown Impact
The Treasury's massive bond buying effort known as quantitative easing came to an end late last year. With the Fed recently unwinding this program, the market impact is yet to be determined.
Furthermore, while the Fed remains in a very accomodative mode, expectations of a likely shift in policy in the future are also causing uncertainty.
More Corporate Credit; Investors Stretch For Yield
Just as investors stretched for yield, record bond issuance rapidly expanded corporate credit. But bond trading has actually shrunk by 7.4 percent in 2014, according to the Securities Industry & Financial Markets Associations. A sudden or rapid rise in interest rates could make these markets more volatile as bonds decline in value and face an exodus of investors.
The Fed has held yields close to zero, and investors have poured money into lower-quality credits and less liquid or infrequently traded bonds. As a result, many investors are more exposed today to credits with higher risk profiles. The market for speculative grade securities has grown 83 percent since the end of 2008. At the same time, Wall Street banks reduced their role of making markets in these bonds and supporting these markets with liquidity during periods of volatility. The Office of Financial Research report also sites this as a potential source of volatility.