Monday, May 7, 2012

Dealers becoming less relevant in corporate bonds, activities linked to new issue volumes

Here is a follow-up on an earlier post discussing dealer inventories. Inventories (bonds held by primary dealers on their balance sheets) have in fact stabilized recently after a prolonged decline. Does that mean the dealers are finally taking some risk? Not exactly. The reason dealer inventories have stopped declining has to do with increased new issuance of corporate bonds. Under the Volcker rule dealers will be permitted to hold some inventory in primary bonds to facilitate new issue business. It is also worth it for dealers to set aside increased capital under Basel-III for these positions because they get issuance fees, significantly improving return on capital.

Corporate bond new issue by quarter (source: Barclays Capital)

Going forward dealer inventory and in particular trading volumes will be increasingly driven by new issue volumes. Dealers will hold and trade fewer "old issue" (secondary) bonds - it will be too costly under Basel-III and may not even be permitted under the Volcker rule. That means that the secondary bond markets, particularly in smaller corporate names will become illiquid. The next chart compares TRACE (trading) volumes to monthly new issue volumes, showing a linear relationship.

(source: Barclays Capital)

But even with stable inventories, primary dealers are becoming much less relevant to the overall market. The chart below compares dealer inventories in corporate paper with mutual funds and ETFs. As discussed before, when it comes to fixed income, ETFs increasingly run the show. The demand for paper and the volatility in cash corporate credit is now driven by ETF-related (and to some extent mutual funds) buying and selling.

Dealer inventories vs. funds NAV (source: Barclays Capital)





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