Monday, February 13, 2012

Pending regulation is squeezing dealer inventories

Here is a quick followup to the post on the unintended consequences in the corporate bond market. The dealer inventory of corporate bonds (both investment and non-investment grade) continues to decline to levels not seen since 2002 when the corporate bond market was a fraction of what it is today. Anyone who has ever been involved in market making - whether it is bonds or baseball cards - knows how important it is to have the flexibility to manage your inventory. Otherwise one simply becomes a broker and the liquidity in the product disappears. In such an environment you can only execute if there is someone on the other side, vs. trading with a dealer who can hold a position until she finds the other side of the trade.

Primary Dealer net inventory of corporate bonds (source: NY Fed)

The pending regulation is putting a squeeze on inventories, rapidly diminishing liquidity, particularly for middle market corporate names. Yes, dealers have less risk on the books because of lower inventories, but the risk to investors is increasing because it will be that much harder to buy and sell securities in a low liquidity environment.
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