In their effort to remove proprietary trading from bank holding companies and increase capital requirements, regulators are destroying liquidity in the US corporate bond market. If you make markets (offer to buy and sell) in any product that has limited liquidity, you must run inventory. Baseball cards, antiques, or bonds - it's the same process. However between Basel III and the Volcker rule, the ability to maintain inventory is being undermined.
Barclays Capital: Increased regulation is a primary cause of this shift in dealer behaviour, in our view, in particular Basel III and the Volcker rule. Basel III significantly increases the risk-weighted assets associated with dealer balance sheets, thus making holding inventory more costly. Several banks have cited this change when noting material decreases in their fixed income balance sheets. For example, Credit Suisse announced that it plans to nearly halve the Basel III risk-weighted assets in its fixed income division over the next three years. Uncertainty about the implications of the limitations on proprietary trading included in the Volcker rule have also led dealers to reduce inventories. While the rule-writing process on that front is still ongoing, absent some substantial unexpected changes, the trend will likely continue towards reduced capital devoted to market making.The dealers have started pulling back on inventory ahead of new regulatory framework The chart below shows the levels of dealer inventory of corporate bonds, both High Yield (HY) and Investment Grade (IG) vs. mutual fund holdings.
Mutual funds tend to be "buy and hold" investors. Therefore price discovery in the corporate bond market comes from transactions facilitated by dealers or dealer quotes. As dealer inventories drop, transaction volumes decline and bid/ask spreads get wider. In other words if you can't add bonds to you inventory or have no bonds in your inventory to sell, you will have to find the other side of the trade before you can transact. If you don't have the other side of the trade ready (and usually market makers don't), you will make markets wide enough to compensate you for the risk of finding the other side later to unload your position.
Another troubling "unintended consequence" of the upcoming regulation is increasing concentrations. Dealers will only make markets in the largest, most liquid names because the smaller names would not justify the capital usage in the new regulatory framework. The next two charts show the transaction volumes for HY and IG bonds sorted from highest to lowest. The most liquid few issues account for the bulk of the volume.
Barclays Capital: As dealers shrink their corporate bond holdings and mutual funds demand higher liquidity, we see an increased risk of volumes becoming even more concentrated than they are currently. Indeed, in the first three quarters of 2011, of the nearly 628 tickers in the U.S. Corporate Index, the 37 most liquid credits accounted for 50% of the volume; only 10% of the volume was in the bottom 412 tickers (Figure 16). The volume concentration is even more pronounced in high yield – 50% of the volume in the first three quarters of 2011 was in 46 tickers (out of 1,140), with the bottom 821 tickers accounting for only 10%Who cares, you might ask. It's the medium-size businesses who are going to get hurt. Because liquidity in their bonds is going to dry up, investors will become concerned that they would not be able to sell these bonds when they need to do so. Therefore they will demand an increasingly higher yield to purchase such bonds (liquidity premium). And the medium size business - who tend to create a great deal of new jobs - will be the ones paying significantly more to borrow money.