Friday, May 9, 2014

As dealer inventories decline, fixed income markets face higher volatility

Dealer inventories in fixed income products remain quite low and have seen especially sharp declines in credit products such as corporate bonds and ABS (treasuries/agencies are Volcker-rule exempt, most other bonds are not).

Source: Credit Suisse

US bank regulators keep insisting that as banks are forced out of market making, someone else will step into their place - either electronic exchanges or buy-side market makers such as hedge funds. That belief is highly misguided. As an example, Blackrock tried an electronic trading platform for bonds in 2012 and failed. Electronic exchanges that have any liquidity these days are either dealer-sponsored or have dealers heavily involved in providing quotes. When it comes to credit in particular, a pure buy-side to buy-side exchange is a pipe dream for now.

What this means is that as dealer inventories shrink to the lows not seen in over a decade, bond trade execution becomes more like a brokered transaction, particularly for the "off-the-run" issues (bonds that have been issued a while back). It goes something like this: You call your favorite dealer desk looking to sell a bond. Your coverage, let's call him Jerry, is a 25-year-old, whose previous job was at Best Buy (he was hired as the bank gutted its sales and trading group). Jerry in turn calls a few of the bank's mutual fund accounts who may or may not show him a bid. If they do, he'll call you back with his bid which has some spread built in. Jerry knows little about the credit (the company that issued this bond), has no market view on the bonds, and has no authority or balance sheet to take any risk on it. He has to have the other side in order to transact. In a crunch situation, there is no other side.

As a result, credit markets have become vulnerable to large uncontrolled market moves.
Credit Suisse: - Declining dealer balance sheets: risk aversion, prudential regulations and capital rules have caused dealers to reduce balance sheets in risk assets. 
Smaller balance sheets raise volatility risk: during times of one way trading, less elastic dealer balance sheets suggest more volatility during periods of forced selling. The sell-off in late spring 2013 may only be a precursor of sharp swings in fixed income markets.
With credit spreads now at pre-recession levels, a great deal of the paper out there is "priced to perfection". Combine that with this lack of market making capabilities and you are asking for trouble.
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