Corporate bond coupons are set to be driven higher and issuance will become prohibitively expensive for small and medium-sized enterprises (SMEs) as US and European regulatory change forces a liquidity crisis in secondary trading and activity concentrates in only the largest, shortest bonds issued by the most trusted names, according to new research by Tabb Group.
Regulators on both sides of the Atlantic are challenging the traditional principal-based, market-making model for corporate bonds, forcing an end-game where bonds will trade like stocks in a transparent, equity-like, exchange framework. “Short term, the effects of such wholesale change will be negative with secondary market liquidity damaged and more fragmented than it already is,” said Will Rhode, a London-based Tabb senior analyst and author of ‘Corporate Bond Trading: Building Networks, Realising Liquidity’.
Based on conversations with corporate bond dealers, agency brokers, interdealer brokers, exchanges, multi-trading facilities (MTFs), multi-dealer trading platforms, data providers, technology firms, trade associations, investment managers and hedge funds, the report describes how regulation is driving change in the way corporate bonds trade globally and looks at the new competitive elements and technology solutions providing alternatives to the existing status quo.
In the US, the proposed Volcker Rule may devastate secondary market liquidity by placing onerous burdens on market makers, hindering their ability to warehouse risk. In Europe, a pre-trade transparency regime, Systematic Internalisation (SI), will force over-the-counter (OTC) market makers to open up bilaterally-negotiated trades to other dealers to compete for the same business. Both measures come at a time when banks are deleveraging in the face of stringent Basel capital requirements, already corroding their appetite to warehouse liquidity.
According to Rhode, over US$386bn in investment-grade corporate bonds were issued in the US in the first 10 weeks of 2012 as yields tightened to 3.27%, the lowest level since 1973, indicating strong demand, driven in part by a strong market in fixed-income exchange-traded funds (ETFs), which grew 25% in 2011 to US$258bn. Dealer corporate bond inventories currently stand at US$46.7bn, down 46% from the previous year and 22% below the credit-crisis low of US$59.8bn as dealers have slashed their bond holdings with a maturity of a year or more by nearly 44%.
“Dealer corporate bond inventories have not been so low since 2002,” said Rhode. “Without market makers to spread liquidity across an array of bonds, only the largest issues by the most reputable firms are able to form sufficient liquidity in the secondary markets.”
For SMEs in need of public funding, coupons will be driven to prohibitive levels. A drag on primary issuance will set a negative, self-fulfilling liquidity cycle in motion. “On its current trajectory,” Rhode warned, “the corporate bond markets may be on the verge of a crisis and a vital funding window for SMEs is about to be closed.”
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