LONDON -- The credit markets can expect to see liquidity fall and volatility rise more than is usual this year-end as banks and investors pull in their horns to preserve fat profits from the corporate bond rally that began in March.
Banks, battered by the crisis, will particularly step back from taking big positions as they try to shrink balance sheets to bolster capital ratios ahead of their financial year-ends in December, analysts said.
"All these factors imply for us that market liquidity probably won't be great," said Hans Lorenzen, credit strategist at Citi.
"Real money investors have lots of cash, but if they remain a little cautious near-term, then it is not easy to see who is going to be taking the other side if banks and other investors want to reduce exposure into the year-end," said Lorenzen, who remains bullish on the credit market outlook going into 2010.
The end of 2009 looks much less scary in terms of liquidity than the end of 2008, when central banks and governments were battling to prevent a global financial meltdown.
"Most trading books will be sitting on a very nice profit, so we would expect even thinner liquidity in December as people try to focus on wealth preservation and bonus preservation - dare I say it," said Phil Milburn, fixed income fund manager at asset manager Aegon.
Investors and investment banks will try to tread water as much as possible.
LOW RISK TO NO RISK
Asset manager Credaris's credit fund currently aims to balance its portfolio to achieve a largely flat exposure to any directional move in spreads at this point.
Sam Cowan, Credaris senior portfolio manager, said as the end of the year approaches people's risk tolerance goes from historically low to no risk.
"Nobody is going to risk anything for that one little bit of upside," Cowan said.
Traders and investors will want to lock-in some profits, but won't want to put too much into actual cash because there are expectations of credit markets moving tighter still.
"Most investors are expecting further tightening in credit markets so you don't want to reduce your exposure too much," said Jeroen van den Broek, credit strategist at ING.
But if there is profit-taking and if the secondary market is illiquid this could mean unusual price moves, he said.
"It will be a position-driven market heading into the year-end, so you might see some anomalies as positions get turned," van den Broek said.
Another factor that could impact liquidity is that the U.S. investment banks Morgan Stanley (MS.N: Quote, Profile, Research, Stock Buzz) and Goldman Sachs (GS.N: Quote, Profile, Research, Stock Buzz) have joined most other banks in ending their financial year in December rather than November.
This means the major investment banks will be tidying up their books and reducing balance sheets at the same time.
In previous years, investment banks would do this a few weeks earlier meaning that they would be operating normally when European banks were sidelined.
This could prompt some anxiety about secondary market liquidity over the year-end.
"I can see the market worrying about balance sheet reduction, but when it comes to funding there is no difficulty for banks this year," said Lorenzen.
"This year, we arguably have too much liquidity in the system and you have 12-month repo from the European Central Bank in December likely to inject more liquidity."
Volatility has started to pick up, partly due to recent gyrations in equity markets.
The Chicago Board Options Exchange Volatility Index or VIX, the financial markets' volatility meter, for example, spiked up on Friday to its highest since July .VIX.
"If you get a day where volatility is shooting up and people are worrying about the sustainability of the economic recovery, then liquidity will dry up pretty quickly," said Gary Jenkins, head of fixed income research at Evolution Securities.
But he said corporate bonds were still in demand even though people were aware that the returns from here on were going to be a lot less than the returns over last 9 to 10 months.
"Credit still offers attractive returns on a relative value basis."
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