Lack of liquidity in corporate bonds - (un)intended consequence of low rate policy
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I was at the Fixed Income Trading & Investing Summit conference earlier this week listening to many perspectives on the fixed income market, particularly corporates. The themes of market structure, liquidity (or lack thereof), regulation, electronification, and new entrants in the space pervaded all conversations, formal and informal. Reflecting on the state of the US corporate bond market, it is difficult to reconcile record new issuance, and record levels of bonds outstanding, with the drop in major dealer inventory by 80% from pre-crisis levels to present. This lack of dealer inventory was recently discussed by SEC Commissioner Daniel Gallagher. In March, Gallagher said that the drop in dealer liquidity could cause “systemic risk”. The SEC is bringing to attention the possibility of a liquidity crisis, perhaps sparked by an eventual rate rise. However, one of the main reasons that dealer inventory is so low, is the evolving regulatory and capital regime make it much more expensive to maintain risk assets on balance sheet. In a sense, an unintended consequence of the low rate policy is potential dysfunction in secondary bond liquidity. Arguably, certain policy makers might have intended to move secondary trading of corporates away from major dealers, as part of general strategy of de-risking the financial system, or at least, as a means of transferring assets from dealers to the buyside. The SEC is now looking carefully at how to deal with the liquidity issue; they seem to desire that the industry offer innovative solutions for providing secondary trading. This liquidity can come from traditional dealers and alternative liquidity sources such as the buyside, or other types of dealers and expanded electronic resources. We are at a juncture in the evolving market structure of corporate bonds. The goal should be for the industry to find the right level of incentives for the dealers to make markets, engage the buyside and their needs, and leverage innovative technology to fill the gaps.