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The market makers reform is a good thing, but it has exacted a price that, in the event of a global pullback in the markets - could devastate the local bond market, predicts Ronen Avigdor of Menorah-Mivtachim.

As long as Israel remained an isolated market, living in a vacuum, it neither gained from the outside world nor suffered from it, Avigdor says.

"Now, following the reform that came into force in September 2006, the situation has changed. Foreign investors are responsible for 10% of the volume of activity in long-term fixed-income Shahar bonds, versus only 1% before the reform, and turnovers have significantly increased," he says.

The reform also introduced new technical aspects to the Israeli marketplace. For instance, it changed the clearing day to the day after the bond is bought (T+1 versus T+0), making it easier for foreign investors who need to convert currency.

Also, the details of the Israeli government bonds are now available on the Bloomberg system, for which purposes some of the bond names were changed to suit the global format style. The primary dealers were given exclusive access to state debt offerings, and green-shoe options to buy more on the day after the offering. Market makers were even given their own separate trading system.

The reform turned Israel bond market into a paradise for foreign investors, says Avigdor, and the state is saving money because of the drop in yields. The market is more liquid, too.

But the mini-crash in Israel's bond market these last days demonstrates the flip side of all that goodness. Before the reform, the only players in Israeli bonds were Israelis, who more or less aped what was happening in the world, but not with the same aggressiveness. Also, the foreigners gauge their activity by foreign benchmarks, the locals by local ones, Avigdor says.

Yields on U.S. bonds shot up from 4.6% to 5.3% at their peak and Israeli bonds promptly lost much of their allure to foreign investors. Also, a lot of the foreign investors busy in Israel are speculators, not in bonds for the long run. The result was a massive selloff of fixed-income Shahar bonds, which sent the dollar climbing in the local market (as they converted the shekels they got for the bonds into dollars), and pressed on the stock market.

It is also absurd, said Avigdor, that at this time of crisis, higher-risk corporate bonds lost less ground than Israeli government bonds, which are safer.

Foreign investors concentrate almost exclusively on government bonds, ignoring Israeli corporate paper. Therefore, that's where their massive exit was felt.

Also, lack of liquidity tends to benefit the corporate debt market. Put otherwise, lack of liquidity serves as a shield when a paper is not moving.

Does all this mean that corporate bonds have become safer than government bones? No, cautions Avigdor. The anomaly may last for a short while, but the relative yields of the corporate and government segments will adjust. Either corporate bond will rise, or government bonds will correct downwards.

If U.S. yields drop, then yields on Israeli bonds will too, he says, but not as low as before the crisis.

Players were simply reminded of the risk premium they need to demand on Israeli paper, he says. Even if the shock in the bond market is history, which Avigdor for one is not sure about, yields will drop - gradually.

At present, Menorah-Mivtachim prefers bonds linked to the consumer price index over fixed-income debt, one reason being predictions that inflation is coming out of the closet. Also, in the event that the shekel weakens, as happened recently, linked bonds will compensate because depreciation translates into inflation, while fixed-income paper will not.

Avigdor doesn't see the Bank of Israel lowering interest rates any more, but he doesn't see it rushing to raise the rates, either. "The Bank of Israel has been wracking its brains for three years how to get inflation back into the target range. It doesn?t want to depress it any more, so even if consumer prices rise, it will wait before starting to fight," he says.