Chandler Bond Market Review

The Volcker Rule: How It Could Affect the Corporate Bond Market

A new federal regulation intended to prohibit banks from making speculative investments in the wake of the 2008 financial crisis, was enacted in December and will take effect starting April 1. Although the regulation, known as the Volcker Rule, was designed to make banks and the entire financial system more stable and transparent, some market analysts contend that it could lead to an array of unintended market consequences.

In particular, some believe that the Volcker Rule could affect the market for corporate bonds — securities that are often used to positively affect yields in fixed income portfolios — by decreasing liquidity and increasing trading costs.

“The full effects of the Volcker Rule are as yet unknown…”

We at Chandler are actively monitoring fixed-income markets for potential fallout from the Volcker Rule and will be communicating our observations and insights. As part of this effort, we thought we’d start with a few Frequently Asked Questions:

How did the Volcker Rule come about?

The rule, named for former Federal Reserve Chairman Paul Volcker, is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the most significant financial reform passed since the Great Depression. The broad goal of Dodd-Frank is to protect taxpayers from financial institutions deemed “too big to fail.”

The Volcker Rule, as a key component of Dodd-Frank, seeks to prevent banks with federally insured deposits from taking excessive risks by trading securities for their own profit. Volcker, who was appointed by President Obama to chair the President’s Economic Recovery Advisory Board in 2009, championed the ban, saying that such speculation by banks contributed to the financial crisis. Other financial experts, however, have described their role as minor.

What took so long?

The three-year delay implementing the Volcker Rule is blamed on a combination of intensive lobbying by the financial industry and squabbling among the five regulatory agencies involved.

What does the Volcker Rule prohibit?

It bans banks, such as Bank of America, JPMorgan Chase, Citibank, Goldman Sachs and Morgan Stanley, from “proprietary trading,” that is, trading conducted for their own gain rather than that of their customers. Specifically excluded from this ban, however, is trading of U.S. Treasuries and the bonds of government-backed agencies such as Fannie Mae and Freddie Mac.

In addition, the rule prohibits banks from holding any interests in hedge funds or private equity funds.

What does it permit?

The Volcker Rule allows securities trading intended to meet demand from customers. Just how banks will determine which trades are proprietary and which are for customers is unknown and likely to take years to unfold.

What effects could it have on the corporate bond market?

We believe that the market may experience:

  • Decreased liquidity – With banks forced to act more as “agents” (having a willing buyer and seller on both sides of the transaction) and not as “principals” (effectively putting one side of the transaction on the bank’s balance sheet), market liquidity will decrease in our opinion. Credit market liquidity has already declined since the onset of the financial crisis in anticipation of the rule’s requirements that banks hold fewer securities and hold only those of high quality. As the Volcker Rule takes hold (full compliance takes effect July 21, 2015), banks will have even less incentive to maintain a large inventory of bonds, thereby shrinking inventories.
  • Higher trading costs – Bid/ask spreads, the difference between the price a buyer is willing to pay and the price a seller is willing to sell, will likely widen as dealers hold less inventory. In particular, the cost of trading seasoned bonds (those issued more than one year ago) could increase as dealers and investors seek to be compensated for the decrease in liquidity due to the length of time passed since issuance. Investors who trade portfolios less frequently could incur higher costs, because such portfolios are more likely to have more seasoned bonds that could over time become more expensive to trade.
  • Shifting trade platforms – Investors are adapting to the changing market by trading directly with one another using third-party platforms such as MarketAxess. Such peer-to-peer trading requires a thorough understanding of market dynamics on a continuous basis. The process is time consuming, as investors need to “wait out” willing buyers and/or sellers rather than have a bank act as an intermediary.
  • Greater volatility – Markets may become more volatile at turning points as dealers have little incentive to keep markets orderly when market sentiment changes. While such volatility might prove difficult for investors who trade infrequently, it could benefit full time investors who understand the risks and opportunities.

These predictions are preliminary. The full effects of the Volcker Rule are as yet unknown and will likely take years to play out. It’s also important to keep in mind that the aim of the rule is to create less risk in the markets. One thing is certain: We will watch the markets carefully and keep you updated on the Volcker Rule as needed throughout the year.

– Ann Perry
     Marketing & Communications Writer


This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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