Wild Swings in Repo Rates Raise Concerns About Bond Market's Liquidity
By Daniel Kruger
Some investors are concerned that recent turmoil in a key short-term cash market where banks borrow to fund operations could exacerbate difficulties trading bonds.
Spikes in the cost of overnight loans using repurchase agreements, or repos, could hit bond trading in two ways, investors and analysts said. Rising repo rates make it more expensive for securities dealers to borrow money and to hold government bonds -- actions they take frequently to facilitate client trades and manage their risks.
In the repo market -- where banks and money-market mutual funds typically lend cash for periods as short as one night in exchange for safe collateral such as Treasurys -- rates surged as high as 10% last month from about 2.25% amid an unexpected shortage of available cash in the financial system.
Bond investors tend to worry about liquidity, or the ability to buy or sell a particular security, because the market doesn't have a central exchange and a lack of trading partners could create wide gaps in prices at times of market stress. Differences in the various features of corporate bonds, which are often issued in relatively small sizes, can also make trading difficult.
"If repo rates keep getting higher, the economics of making markets is going to be that much worse," said Peter Yi, director of money markets at Northern Trust. Elevated repo rates could make bond dealers "more selective" about the securities they are willing to buy from customers and hold on their books, making trading more difficult at times of market stress, he said.
Rates surged in the middle of last month after falling reserves in the financial system, together with a handful of large cash drains including a large corporate tax payment and a government-bond auction, prompted many banks to hold on to cash rather than lending it in the repo market.
In the days following the jump in repo rates, the Federal Reserve said it would provide billions of dollars in short-term loans to add liquidity to the financial system. In more recent offerings, banks requested less money than the Fed has been willing to lend, even though a large gap between the rate the Fed lent at and what banks charged has persisted.
The Fed said Friday it would offer a new round of overnight cash loans in the coming weeks, as well as more new loans that have two-week terms and mature later this month through early next month.
While the Fed has lent money overnight through the repo market at a typical interest rate of about 1.9%, traders have said that banks have frequently offered repo loans at rates around 2.5%.
The issue of bond market liquidity could become particularly pressing if sentiment about the economy worsens, investors said. That's because the steady growth of the economy, along with Federal Reserve interest-rate cuts, has supported bets on investment-grade and high-yield bonds.
That could lead many investors with large wagers to reduce their holdings at the same time. If those overwhelm the available buyers, it could lead to large price declines, investors said.
Some investors said bond dealers in recent years have been less and less willing to make markets in bonds sold by companies and even in supersafe government securities. Many dealers use money borrowed in the repo market to finance bond purchases, so increases in that rate could make them more reluctant to buy bonds.
"The only liquidity in the market is the customers," said Mark MacQueen, who manages bond portfolios as a principal at Sage Advisory.
-- To receive our Markets newsletter every morning in your inbox, click here.
Write to Daniel Kruger at Daniel.Kruger@wsj.com