Dealer inventory slump threatens market stability

Fri Mar 22, 2013 11:13am EDT

LONDON, March 22 (IFR) - The combined effect of dealers slashing bond inventories and fixed-income funds growing rapidly over the past few years has led to a precarious situation in which even a small migration away from bonds and into other asset classes could spark huge volatility in cash and derivatives markets.

Dealer holdings of corporate bonds have shrunken to a fraction of their previous size over the past five years, as banks become more risk-averse and regulatory capital weightings discourage warehousing of large positions. At the same time, inflows into bond funds have surged, with many individual funds now holding vastly more corporate bonds than the entire position held by dealers.

Talk of a "great rotation" into equities has petered out as economic growth in the eurozone continues to stagnate, but dealers say that if and when a shift from bonds into other asset classes finally emerges, the fallout will reverberate across financial markets.

"Dealer inventory is a massive issue. The Street couldn't cope with a rotation of more than 2%-3% out of bonds," said Niall Cameron, head of credit trading at HSBC. "There would be massive gapping, similar to other financial crises such as Asia and Russia in the 1990s and the 2008 financial crisis."

Data from the Federal Reserve Bank of New York show that US dealer inventories of corporate bonds have trended downwards dramatically from a peak of US$235bn in 2007 to US$55bn currently, dipping as low as US$40bn in mid-2012.

"Dealers have been forced to operate with inventories of only 0.5% of outstanding debt. Compared to historical levels of 4%-5%, this is a very low number," said Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura.

"Unfortunately the velocity in the secondary market has not increased by enough to offset the drop in liquidity caused by the fall in inventories. exposes the system.

"There is a growing concern that a small amount of selling can have a disproportionate impact, given reduced dealer capacity."

Bond funds saw over US$1trn of net inflows from the beginning of 2009 to the end of 2012, according to Lipper. This has been coupled with a notable uptick in fixed-income exchange-traded product flows, which have grown US$168bn since the start of 2010, according to BlackRock.

Rampant bond issuance has helped to feed this demand. Thomson Reuters data show that global corporate bond issuance since the start of 2009 is only a touch shy of US$6trn - around double that of the preceding four years.

TOO BIG TO SELL?

The upshot is that bond holdings by the world's largest funds now dwarf those of all the major bond dealers put together. Amundi, for example, has assets under management of 727bn euros, 52% of which are bonds.

"Buyside investors often express concern over the liquidity of their cash portfolios," said Jonathan Moore, head of European credit trading at Credit Suisse. "Over the past five years we've seen massive inflows into fixed income. If and when flows start heading out, where does the bid for these bonds come from?"

Many believe the intense bout of volatility that struck credit markets in August 2011, when the sovereign crisis ramped up, was a sign of things to come. Much of the price action was seen in the derivatives markets, with the iTraxx Main index whipsawing around in 100bp ranges each day.

HSBC's Cameron estimates that this was on the back of only 1% outflows, predominantly due to dealers re-sizing inventories.

Whether a wider bond selloff will actually materialise is still under debate. Some analysts have reached the same conclusion for private bond holdings as they have for central bank quantitative easing programmes - perhaps letting positions roll off naturally over the course of many years will be the answer. Many asset managers increasingly use derivatives indices to hedge cash positions rather than exit them altogether.

"I think the great rotation was wishful thinking. We've seen a slow pick-up in volumes but from very low levels," said Patrick George, head of equities at HSBC. "Traditionally people have moved to equities because of higher growth prospects - which we haven't yet seen in Europe - and you wouldn't expect a rotation out of bonds until the wider environment improves."

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