Illiquidity in Fixed Income Markets, Part I: Death of the Dealer Model

U.S. fixed-income markets are in transition because of new regulations and Federal Reserve policy. The decline of the broker-dealer market-making model is causing a shortage of liquidity, which would pose risk to investors should the great bull run in bond markets come to an end. Deep, liquid markets are important for financial stability and expand access to capital for individuals and corporations.

Select banks called primary dealers, among them J.P. Morgan, Goldman Sachs, and Citigroup, traditionally played an important role in “making” bond markets by providing liquidity, holding inventory of their own, and acting as the counterparty for trades by quoting bid and offer prices. Because bonds have unique durations, covenants, and rates, and are overall less standardized than equities, they are less frequently traded and have fewer investors, making intermediaries such as dealers necessary.

Two factors have caused institutional investor bond holdings to rise substantially and dealer inventories to fall. Basel III’s higher capital requirements and supplementary leverage ratios, and Dodd-Frank’s Volcker Rule, have decreased the profitability of dealers who trade and carry bonds on their balance sheets, prompting them to retreat from the traditional dealer model and focus on their core businesses. At the same time, years of quantitative easing by the Fed have caused investors to leave government fixed-income securities for high-yield and investment-grade corporate bonds (and equities) in pursuit of bigger returns.

Chart 1

Source: Bloomberg, ICI, NY Fed, SIFMA.

The confluence of these factors has constricted the supply of fixed income to investors on the secondary market, while demand has risen. Dealer holdings of bonds have fallen to an all-time low, down 89 percent from their 2007 peak, while mutual fund holdings of bonds more than doubled in the same period. This means the amount of mutual fund credit assets susceptible to declines in liquidity equals nearly $870 billion versus $300 billion during the credit crisis in 2008.

With the inclusion in those assets of exchange-traded funds that track corporate debt, buy side bond holdings further exceed dealer inventories. In part, the huge resurgence in the issuance of traditionally illiquid securities in 2013 (i.e., leveraged loans, CDOs, CLOs, corporate hybrids, and convertible bonds) stems from attempts to satisfy the supply-demand mismatch in fixed-income markets.

On the surface, market liquidity seems to be healthy, but closer inspection reveals that is not the case. Despite high trading volumes, other aspects of liquidity have suffered: bid-offer spreads that spike when liquidity is needed; less diverse market participation and a concentration in fewer bond categories; weaker dealer participation in Treasury auctions; and thin trading in older and smaller bonds in secondary markets. Because of the issuance boom, investors mainly are buying new bond issues and have not needed to rotate into other portfolios.

Furthermore, large block trade volume has waned over the past eight years. Block trades worth more than $5 million have decreased, and those in the $1 million to $5 million range have increased. The average trade size has declined due to more dealers splitting up large orders to find buyers and sellers. In retrenching, dealers are focusing on their largest clients, often leaving smaller funds struggling to complete trades affordably and further narrowing market participation and the strategies used for trading. Financial institutions are trying to remedy these issues by developing electronic bond trading platforms to facilitate liquidity.

Illiquid markets present both volatility and risk to investors. Unlike the dealers, institutional investors cannot act as liquidity stabilizers, risk warehouses, or pressure release valves. When the corporate bond bull market ends, investors, not dealers, would bear the brunt of losses as the latter are no longer positioned to take on all the bonds investors would want to offload.

Funds have built up big positions in corporate debt and taken on less liquid securities with higher yields to help meet expected returns or actuarial assumptions. If those funds should need liquidity stemming from a jump in nonperforming loans or market volatility, the door under the Exit sign would quickly become very crowded. Numerous factors could trigger this, including rising interest rates, deflation, an international financial crisis—anything that affects credit or causes defaults to multiply. It would inflict massive stress on those funds and a jarring impact on the economy, undermining the financial futures of pensioners and annuity holders.