Updated Friday, October 31, 2014 as of 12:54 AM ET

Bond's Liquidity Threat Is Revealed in Derivatives Explosion

(Bloomberg) -- The boom in fixed-income derivatives trading is exposing a hidden risk in debt markets around the world: the inability of investors to buy and sell bonds.

While futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year. In Japan’s $9.6 trillion debt market, the benchmark note didn’t trade until midday on two days last week. As a lack of liquidity in Italy caused transaction costs in the world’s third-largest sovereign bond market to jump last month, Lombard Odier Asset Management helped propel an eightfold surge in Italian futures by relying more on derivatives.

The shift reflects an unintended consequence wrought by central banks, which have dropped interest rates close to zero and implemented policies such as buying debt to restore demand in economies crippled by the financial crisis. Inefficiencies in the $100 trillion market for bonds may make investors more vulnerable to losses when yields rise from historical lows.

“Liquidity is becoming a serious issue,” Grant Peterkin, a money manager at Lombard Odier, which oversees $48 billion, said in a June 11 telephone interview from Geneva. The worry is that when investors try to exit their positions, “there may be some kind of squeeze.”

That concern has caused investors to pour into derivatives, which are contracts based on underlying assets that can provide the same exposure without tying up as much capital.

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