Friday, July 20, 2012

As dealer inventories shrink, corporate bond liquidity is drying up

US dealers are continuing to reduce inventories of corporate bonds in anticipation of the Dodd-Frank regulation. The inventories are now at the lowest level in a decade.

US dealer inventories of corporate bonds ($million)

Yet the corporate debt market has more than doubled from 10 years ago (now at over $8 trillion). Currently US banks hold less than half a percent of the corporate debt outstanding.

US corporate debt market (source: SIFMA, $bn)

Being a market maker with such tight balance sheet constraints is next to impossible. That's why banks are only concentrating on the largest names and mostly new issue bonds.
LCD: - Barclays analysts warned in the first quarter that liquidity has “become increasingly concentrated among the most active parts of the market, making large parts of the market very difficult to trade, as dealers decreased their corporate bond inventories ahead of anticipated regulatory changes.” [see this post from last December on this warning]

As reported, trading volume has averaged less than $10 billion per session on the high-grade secondary market so far in July, down from a July 2011 average of roughly $11 billion, and on track for the lowest average since the $8.6 billion in December 2011, according to MarketAxess. The decline in trading volume comes after a marked decline in the turnover rate for high-grade corporate bonds in the second quarter, underscoring the disproportion of trades in relatively few larger-scale issues.
This is going to create a problem for medium size US corporations because all the liquidity will continue to shift toward the largest issuers. Thus Dodd-Frank in its ultimate wisdom has raised barriers to entry into the debt markets for middle market US companies. Congratulations.
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