Institutional investors have confirmed that much-reduced dealer inventories of corporate bonds is the “new normal” in Europe and the US, and agree this poses risks to their portfolios, according to a new Greenwich Associates survey.*
But the study also shows that most (57%) of buy-side firms consider themselves a viable source of additional corporate bond liquidity and 55% believe this could offset the reduction in dealer-provided liquidity.
“With its outsized portfolio of corporate bonds, and utilising new electronic-trading mechanisms, the buy side can help itself by matching off buys and sells without a dealer in the middle,” noted the report. “While this idea has been discussed continuously for several years, it’s only now that we’re seeing real signs that it is happening.”
Nearly 30% of respondents are acting as price-makers or planning to do so in the next 12 months, with asset managers leading the charge. (Price-maker does not mean market-maker, however, stressed Greenwich; that role will remain the responsibility of dealers.)
In fact, ideas are being floated whereby dealers would collaboratively access buy-side inventory to make markets. They would use mechanisms that work like a covered option, but under a legal structure more suitable to the bond market, noted the report.
Dealers often receive client requests for bonds they don’t hold, while investment funds may have these bonds in their portfolios, but earmarked to be held to maturity. Current proposals would allow investors and dealers to agree to the terms of a future trade, specifying the quantity, price and timeframe as well as the fee or other incentive for the bond holder.
For the idea to work, the incentive the dealer provides to the investor would need to be less costly than the dealer’s balance-sheet cost of holding a similar position internally, continued the report. The investor, in turn, would need to receive alpha, better allocations or other sufficiently compelling benefits.
Around half the institutional investors (52%) surveyed by Greenwich were intrigued by the idea. However, 24% were not interested, citing as their primary concerns the complexity of the process, internal accounting issues, and finance and compliance departments not knowing how to handle the risks and returns.
Meanwhile, some ideas have been proposed aimed at lubricating the corporate bond market that would fall under the category of regulatory fixes, noted Greenwich.
Further delaying the reporting of large or illiquid trades could, in theory, provide dealers more time to hedge or unload those positions. But the idea doesn’t align with the increased transparency that fixed-income market overseers are promoting, said the report.
Moreover, issuing bonds with standard maturities, somewhat like index credit-default swaps (CDSs) or US Treasuries, could create fewer, deeper pockets of liquidity. But this approach does not fit with the needs of most corporate treasurers, who look to the bond market for on-demand financing needs, noted Greenwich.
“If secondary markets became so strained that banks are compelled to dramatically reduce fees for standard maturity bonds, issuers might sit up and listen,” added the report. “But until that time comes, widespread adoption is unlikely.”
Meanwhile, some suggest that reviving the single-name CDS market could also boost liquidity in corporate bonds, noted the report. At a minimum, a more robust single-name CDS market would offer participants an efficient investment alternative, particularly if the number of covered reference entities were materially expanded.
“Smart money doesn’t rely on regulatory fixes, however,” concluded the report. “The market must continue to evolve via new tools and approaches that ensure credit continues to flow without interruption.”
* The report polled 58 institutional investors across Europe and the US.