The problem with bond market power November 9, 2013 at 2:06 pm

Peter Lee in Euromoney points out that while dealers’ bond inventory has been going down, the big funds have got bigger.

Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt.

Felix Salmon picks up the story and reposts this chart from Citi as evidence:

Congress

As the title hints, what is at stake here is the declining ability of the markets to absorb risk. Twenty years ago, dealers would make ‘risk’ prices for big blocks, committing their balance sheets to take on customer blocks in exchange for a return. That’s rare now, and become rarer. Dealer inventory has declined too as it becomes more costly in capital to hold. The net result is not just a market with wider spreads and less certainty of execution; it is also one that is becoming more and more vulnerable to even mild selling from the two buy-side leviathans, Pimco and Blackrock. It is no one’s interest that these firms are now so big that they cannot change their positions meaningfully without causing market disruption.

3 Responses to “The problem with bond market power”

  1. I would think the end game is that the role of broker-dealers in absorbing bond risk will be replaced by capital structure arb funds. They certainly don’t have anywhere near the balance sheet of the banks, but equity hedging and moderate leverage should allow them to absorb a fair bit of credit risk. In effect acting as liquidity providers that off load most of the risk on the equity markets.

    If dealers exit the game bond prices will start becoming more dislocated, especially during periods of high flows. The capacity and returns to capital structure arb should increase quite sizably. The major downside here is that hedge funds are a lot more flight-y than banks. So periods of economic stress will be marked by a lot more bond market disruption than under the broker-dealer model.

    The third alternative that I haven’t seen mentioned anywhere is for long-only institutional managers to overlay capital structure strategies. If bond prices do start becoming more dislocated a long-only manager that’s skilled at buying bonds when they’re cheap and equities when they’re not should be able to sizably enhance yield. This model has the advantage over the hedge fund model of being a lot less contagion-prone.

  2. Doug – I see your point, thank you, that’s interesting. My worries would be first is there any likelihood of enough capital being assigned to these funds to play that role (given the shaky performance of cap struct arb since its inception) and second can the equity market support the hedge? The latter might not be an issue, I’m not sure; but if you want to buy say $1B of underpriced bonds and hedge by shorting the equity is the delta of that position small enough that you can get the short done without being destroyed by the borrow? Thank again though – fascinating comment.

  3. so to ‘too big to fail’ and ‘too big to jail’ we can add ‘too big to deal’