(July 12): For the first time in recent history, primary dealers have gone net short on debt they used to hold billions of dollars of.

According to data compiled by Crisil Coalition Greenwich going back to 1998, this first-of-its-kind shift has left dealers holding an aggregate net-short position in corporate bonds of roughly US$4 billion (RM16.3 billion) so far this year. To put that in perspective, those institutions carried a peak US$16 billion of average inventory over 2017.

Running a net short position means dealers have effectively sold more corporate bond exposure than they actually own. They can do this by, for example, borrowing specific corporate bonds via securities lending markets to then sell.

Whatever the mechanics, this multi-billion-dollar short position has left market participants wondering whether dealers are exceedingly reluctant to hold bonds now because they fear the sector will weaken, or investors are so eager to buy the securities that banks can’t keep up with their demand. Another possibility: developments like electronic trading have made the market more efficient, so banks don’t need to keep much, or even any, inventory of securities on hand.   

The reality is likely a mix of all of the above.

For some top corporate bond traders at Wall Street’s biggest banks, the recent positioning is at least in part a directional bet on US economic prospects amid a raft of geopolitical concerns. Credit spreads on corporate bonds are near multi-decade lows, yielding around 0.74 percentage point more than Treasuries for much of this week on average. 

Dealers aren’t getting paid much to take credit default risk now, but risks still abound: inflation is sticky, elevated interest rates can squeeze company balance sheets, particularly if there are further rate hikes.

That may explain why Wall Street firms are more short when it comes to intermediate and longer-term notes, where bond prices are more vulnerable to shifts in yields. Dealers are short on roughly US$13.7 billion of bonds maturing in five years or more, on average this year as of the end of June. Offsetting this is a US$9.66 billion long position in shorter-dated debt, leaving an overall net-short exposure, according to Crisil Coalition Greenwich’s analysis of Federal Reserve data. The figures reflect cash bonds and not potentially offsetting risk such as credit derivatives.

“Obviously the narrative changes day-to-day whether or not they’re going to hike or hold or cut, but it does seem like it is notable though that it is quite clearly the long end that’s short,” said Kevin McPartland, Crisil’s head of research for market structure and technology. “That can’t be a coincidence.”

Before the financial crisis, primary dealers often functioned as a sort of buffer for the market, buying corporate bonds from clients that were looking to offload risk, sometimes even if it meant holding onto bonds for some time. But post-financial crisis regulation curbed their capacity to hold such inventory, just as the market’s rapid automation has shrunk the costs of trading, and what some dealers pocket. Some regulatory restrictions are loosening now, but that doesn’t mean dealers will want to take considerably more risk.

The negative value for inventories is probably also a function of how strong demand has been for corporate bonds— in some sense, dealers can’t keep the product on their shelves. Investors that have liabilities to fund and focus on getting higher yields, such as insurance companies and pensions, have been big buyers of corporate bonds in recent years. On top of that, bonds in money managers’ portfolios are paying higher yields, giving them more cash to reinvest in the market and fueling more demand.  

Some say current inventory levels are less a sign of impending fear and more a reflection of an evolved market.

“Lighter dealer inventory doesn’t necessarily mean the market is bracing for a selloff, rather it’s a product of a more stable market structure,” said Sam Berberian, global head of credit trading at Citadel Securities. The corporate bond market recycles risk more efficiently than it used to, while strong investor demand for yield means dealers don’t need to warehouse bonds as much, he added.

“Tight spreads warrant a measured approach, but the underlying market remains healthy,” he said.

Dealers have tools to offset bond shorts including credit derivatives, exchange traded funds, and other instruments that can offer correlated long positions. Desks have also consolidated, meaning a single team often juggles bonds, ETFs and macro financial products all at once, enabling them to more fluidly manage risk across a portfolio.

A boom in electronic execution, algorithmic and portfolio trading — where baskets of bonds are bought or sold in a single transaction — has injected new liquidity into fixed income, allowing primary dealers to instantly match client flows without warehousing the risk. 

Electronic execution now accounts for 49% of investment-grade and 32% of high-yield corporate bond trading, according to Crisil data. A little over a decade ago, those figures stood at 8% and 2%, respectively. Portfolio trading has also expanded, now making up 11.8% of corporate bond trades year to date, up from 2% in 2019.

“Dealers don’t feel like they need to hold bonds on their balance sheet in order to provide liquidity in the market anymore,” said Ted Husveth, US credit managing director at Tradeweb.

Crisil noted in its report that recent weekly data showed signs of a shift back toward positive territory, particularly for five-to-ten-year bonds. Determining if this is a longer-term trend is difficult, according to McPartland.

“In the end, there’s a macro component and there’s a market structure component and trying to determine which one is a bigger impact is really, really hard,” he said.

Making markets can require firms to be nimble, and being positioned for a weaker market can expose firms if corporate bonds stay stable or even rally, and demand remains high. 

“The risk in that short position is its asymmetry,” said Benjamin Dietrich, a fixed-income portfolio manager at Lazard Asset Management, noting that typical holders of longer-dated bonds are pension funds and insurers with similarly lengthy liabilities — who rarely sell their holdings.

“If yields fall or spreads tighten and dealers are forced to cover into a market with limited available supply, the covering itself can amplify the rally,” he said. “Positioning that looks comfortable in a stable market can unwind quickly.”

Uploaded by Magessan Varatharaja