Efforts to make the global financial system safer could be making Asia more - not less - vulnerable to any credit market shocks, leaving bond traders worried that a sharp sell-off since late May could turn into a rout.
Low global interest rates have made it easier than ever to sell new bonds denominated in dollars, euros or yen, resulting in a boom in issuance that has made Asia and its companies ever more dependent on debt.
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But the market for trading those bonds is slowly drying up, leaving it susceptible to a sharper sell-off if holders of these so-called G3 bonds decide it is time to head for the exit.
"The issue is that if any of them choose to sell their holdings, the market may not have the capacity to absorb these flows. If we reach a stage like that then liquidity could dry up very quickly and that can have a spiraling effect," said Dhimant Shah, a fund manager at Mackenzie Investments in Singapore.
Bond markets in Asia have generally trended higher since the Lehman crisis during the global financial crisis in 2008, partly aided by the flood of cash from Western central banks aimed at reviving their economies. By one measure, a JP Morgan basket of credit, the debt market hit its highest level in May since the global financial crisis.
In the last month though, bonds have stumbled on jitters over when the U.S. Federal Reserve will start to unwind its stimulus program. Yields, which move inversely to prices, on the debt tracked by the JP Morgan basket have jumped in the past month more than 60 basis points, largely in the past two weeks. The yield on Indonesian government bonds due in 2020 have risen even faster, nearly 100 basis points in the past month.
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Asia's low market liquidity could create a more explosive sell-off in which a lack of trading creates a price vacuum, leading to sharper price declines as investors scramble to sell assets for cash, a scenario similar to the dark days of the Lehman crisis.
"I don't recall in recent memory bonds falling so quickly without a tail-risk event as they did in the last month," said Richard Cohen, head of credit trading in the Asia Pacific for Credit Suisse. Tail-risk refers to a sudden event that has a major impact on financial markets.
Unlike equity and currency markets, there is no central repository for information on bond volumes. But dealers said volumes have fallen sharply as the market has sold off, although more generally liquidity has also been sliding in the past year as the result of some powerful factors.
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Regulations under new Basel III capital requirements and the Dodd-Frank legislation in the United States are forcing Western banks to cut global operations, trim, or even eliminate their own bond trading operations and to cut Asian bond portfolios to reduce risk.
For example, fund manager Shah, 41, left J.P. Morgan Chase & Co in Singapore as head of proprietary trading last year, one of many traders who left banks as the stricter capital requirements made it tougher for them to conduct proprietary trading.
At the same time, Asian banks have not developed the expertise or the risk-appetite to fill the void.
In addition, the same low interest rates that make it easy to sell new bonds are making older bonds more attractive to hold rather than trade. The result is a diminishing amount of secondary trading in Asian bonds.
The combination of factors makes it more difficult for sellers, said Hong Kong-based Fredric Teng, a partner at hedge fund Oracle Capital Limited.
"It's a bit like Tom trying to get out using Jerry's pet flap. If investors cannot get out we could have crazy knee jerk price actions," Teng said.
Such a squeeze could have far reaching consequences in Asia given its growing appetite for debt.
The region's debt-to-GDP ratio rose to 155 percent in mid-2012 from 133 percent in 2008, data from McKinsey Global Institute, a unit of consulting firm McKinsey & Co, shows. It is also higher than 1997, when several economies in Asia buckled as capital fled the region.
To be sure, there is no sign of widespread panic in markets. Historically low interest rates, and in some cases a relaxation of regulations governing bond markets, are keeping new issues of bonds at record levels.
G3 bonds issued by Asian borrowers outside Japan hit a record high in 2012 of $133.8 billion and the momentum has intensified this year. In the first five months of 2013, nearly $88 billion in G3 debt has been sold, up from $71 billion in the same period last year.
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But the selloff is the first sign that a bull run in bonds of more than four years may be coming to an end as investors anticipate the U.S. Fed easing back on its stimulus pedal. That risk means investors are wary of some areas of the market.
Bonds from single "B" rated China property companies, sovereign issuers such as Sri Lanka, Vietnam and Mongolia and infrequent borrowers that make $100-$200 million offerings are struggling for buyers. Trading liquidity in these bonds is low anyhow, so during times of market caution, buyers retreat further.
"If you are holding those names good luck trying to sell. Even though things have cheapened up considerably, traders don't want to hold some of these bonds because there may be no buyers," said a Hong Kong-based trader at a U.S. bank. He declined to be identified because he is not authorised to speak with the media.
But there is also a flip side.
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Bryan Collins, a portfolio manager at Fidelity International, says that while bouts of bond market illiquidity are a risk, they also help to remove some of the frothiness from bull markets.
Ultra-low interest rates have fuelled record issuance of new debt, but they have also helped reduce the risk of debt default as many companies refinanced outstanding debt into longer-dated maturities.
That means that, even if yields on 10-year U.S. Treasuries lurch higher after a 64 basis points rise since early May to 2.26 percent, it is unlikely to cause panic among cash-rich Asian companies.
And as a rise in interest rates causes a corollary fall in bond prices, some global fund houses, such as T. Rowe Price, are waiting in the wings to buy up beaten-down debt.
Still, T. Rowe is hedging its positions with safe-haven U.S. and German government debt, said Terry Moore, a fixed-income portfolio specialist at the U.S.-based firm.
"So when volatility spikes in the bond market, we have some liquid bonds we can sell to buy less liquid debt," said Moore, a member of an investment team overseeing more than $800 billion in assets.