Strains in US government bond market rattle investors?

March 12 (Reuters) - Liquidity in the U.S. $17 trillion Treasury market has deteriorated to the degree that the Federal Reserve or U.S. Treasury Department may need to start new programs to buy the debt, or risk large scale liquidation of the bonds, a Bank of America strategist said on Thursday.

Investors this week have said that it has been unusually difficult to trade Treasuries and that the spread between the cost of buying and selling bonds has widened dramatically, making them more expensive to trade.

On Wednesday, Treasury yields on long-dated bonds rose even as stock markets plunged, which Bank of America sees as an additional warning signal, as safe-haven assets should typically rally during such a large equity decline.

"In a risk-off environment it would be expected to see (Treasury) yields decline; yields appear to have been overwhelmed by liquidity concerns yesterday," strategist Mark Cabana said in a report.

If illiquidity in the market persists some market participants including leveraged investors, who are large buyers of bonds, may be unable to hold on to the debt and that could lead to a chain of widespread selling, Cabana said.

A popular strategy by these investors is to buy Treasuries and hedge the debt with interest rate futures. This is profitable because the Treasuries trade at cheaper levels than futures.

The risk is that sustained illiquidity in bonds, however, would cheapen the debt against overnight index swaps, leading these investors to cut their bond holdings on a large scale.

"This would essentially result in a Treasury "supply shock" as these funds reduce their positions & force dealers to sell those positions in a very illiquid market," Cabana said.

As sharp rise in yields rise from this move could force liquidations from other similar investors and make it more difficult for dealers to intermediate trades.

Investors that are less reliant on leverage at this point could also be hesitant to buy bonds on concerns that market conditions will get even worse.

Deteriorating liquidity would make it difficult for investors to price other markets and could lead to large liquidations across credit markets and stocks, while also making it more difficult and costly for the U.S. government to fund itself, Bank of America said.