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
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
"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
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."