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Bond market liquidity risk a primary concern for US fixed income markets, says Tabb

Quantitative easing, reduced trading revenues and bank regulations are colliding to reshape the US fixed income markets, according to Tabb Group in new research, “US Fixed Income Trends: State of the Industry 2012.”

“The old business model of dealers holding bond inventory is dead,” says Henry Chien, a Tabb research analyst who co-authored the report with contributing analyst Deepali Nigam. “New platforms and products in today’s credit bubble are driving new liquidity dynamics.”

Dealers have reduced corporate securities inventory by 40 per cent from 2008 and, in spite of a low interest rate environment, they are not levering up again as they did in the past. Meanwhile, a record primary issuance boom has seen the bond market grow by nearly 40 per cent in notional outstanding during the same period. This leaves institutional investors holding the majority of corporate bond inventory and liquidity risk is a primary concern. Declines in single name, credit default swap (CDS) volumes make them a less viable option for hedging, driving a deeper desire among asset managers to trade cash.

“The buy-side will have to find ways to trade with each other if they’re unable to sell bonds back to the dealers they bought them from,” says Nigam. “Once interest rate volatility returns, there will be a huge impact on the net asset valuation of their fixed-income portfolios.”

New bond trading liquidity pools are emerging for this reason, says Chien. Electronic volumes are currently at 22 per cent of the cash market, driven in part by significant growth in odd-lot trading. Asset managers and exchange-traded fund market makers find some odd-lot alternative trading systems (ATSs) an attractive destination that successfully pool institutional and retail liquidity.

“Electronic is no longer a voice equivalent to the screen,” Chien says. “Innovative protocols and new order-flow networks such as block crossing systems also have a place in this new fixed-income universe.”

Trends in asset allocation favour US markets: US bond funds saw over USD150bn in cumulative flows in 2012 with issuance in the primary market at an all-time high in 2012.

New venues for secondary market liquidity are growing rapidly. Electronic volume is now 22 per cent of customer volume, concentrated in RFQ protocol trading systems and ATSs. Block- trading networks will look to expand and further grow electronic volumes.

Evolution of the secondary market is evident: new liquidity dynamics in corporate bond markets are already having an impact; overall turnover has declined, trade sizes are down and odd-lot volumes are up.

The market for credit-related derivatives is shifting away from OTC products. Single name CDS average daily gross notional volume is down 20 per cent 2012 YTD from 2011; index CDS is up by five per cent at USD42bn in notional ADV.

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