Liquidity drying up in debt markets

When Ray Humphrey sensed trouble in the market for Canadian provincial debt, he reckoned if he didn’t sell right away, he may not be able to sell at all.

The New York-based money manager for Alliance-Bernstein LP reduced his provincial holdings at the beginning of the year, and in the last three months, the securities posted their biggest quarterly loss in over two decades.

The reasons for the rout were partially technical. The provinces were caught in a global sell-off that hit longer-maturity debt hardest, and it wasn’t that Humphrey didn’t like them as long-term investments — provincial finances are generally improving. Rather, he got out because he noticed the debt was getting harder to trade.

“Liquidity is terrible in those bonds,” Humphrey said, referring to notes from the less indebted provinces, such as Alberta. “That’s really where we see the cracks in the system.”

Provincial bonds lost 3.7 per cent in the last three months, the worst quarterly performance for the sector since 1994, Bank of America Merrill Lynch index data show. Federal government bonds lost 2.6 per cent and corporate debt declined 2.2 per cent during the same time.

Concern liquidity is drying up has intensified as the global bond rout that erupted in April erased more than a half a trillion dollars from sovereign debt and triggered swings in prices that some have likened to a once-in-ageneration event. Marketbased interest rates shot to the highest in nine months.

Provincial bonds are particularly susceptible to the anxiety because the average duration of the securities, at nine years, is longer than the six and seven-year averages for corporate and government debt. As rates rise, the prices tend to fall more because holders are stuck with a fixed interest coupon over a longer period of time, resulting in the value of the securities being discounted.

With the Federal Reserve expected to push global rates even higher later this year by raising its benchmark rate, concern is growing it will only get harder for investors to sell provincial holdings. The worry for provincial treasurers is that liquidity concerns will lessen demand for the debt, making it more expensive to borrow.

In the recent sell-off, it was the provinces with less debt outstanding, or the less liquid borrowers, such as Alberta and British Columbia, that saw their borrowing costs inch up. At the same time, the spreads for bonds from Ontario and Quebec, the most indebted and most liquid, were unchanged, according to Merrill Lynch data.

There has been $11.6 billion of provincial bonds sold in the second quarter, down from $19.4 billion in the first quarter and from an equal amount in the second quarter of last year, the data show.

“There has been a significant slowing at a time when issuance is usually one of the busiest,” said Warren Lovely, head of public sector research and strategy at National Bank. “Liquidity is influencing where investors are valuing these provinces one to another.”