A new reality

Dan Fuss likes to describe the structure of the corporate bond market as resembling an ice cream sandwich: bonds change hands between the two crispy wafers on either side, but there’s a fluffy layer in between that facilitates each transaction.

“It’s a good sandwich if there’s a whole bunch of ice cream on the inside,” says Fuss, a bond market veteran who runs the $21.9 billion Loomis Sayles Bond Fund. But in recent years, that creamy inner layer, commonly known by the less appetizing title of “dealer,” has been melting.

Dealers were once powerful arms of Wall Street’s biggest investment banks, such as Merrill Lynch, J.P. Morgan and Lehman Bros. They used their large trading desks to make markets for investors to buy and sell securities. But the shifting roles of these large banks since the financial crisis, often pinned on financial regulations like the Volcker Rule, has caused a steep drop in the volume of debt securities these investment banks hold.

The cushion protecting fixed-income investors from market shocks, particularly in the $6.6 trillion corporate bond market, is melting, which is creating a new form of risk when it comes to buying these securities. In response, investors are reevaluating how they hold bonds sold by companies from Apple Inc. to Ford Motor Co. to DreamWorks Animation, as well as reshaping how they interact in the secondary trading market. The changes have served as a key factor eroding the traditional conviction that the bond market shields investors from risk.

Liquidity drought Created by Terrence Horan

The financial crisis forced the surviving Wall Street banks to reduce risk in a hurry. Many have downgraded their roles as market-makers for corporate bonds, taking fewer bonds onto their books for future sale. Market participants blame the constricting regulatory forces of capital requirements and the post-crisis Volcker Rule. Regulators have pinned the blame back on the banks, which raced to shed less-liquid assets even before regulations were enacted.

At the same time, a surge in new bond sales has increased the size of the market even as dealers, the key facilitator to helping those bonds change hands in the secondary market, have become less willing to handle them. The result is a bond market which is flush with new securities but hobbled when it comes to pricing and trading these securities after the initial sale. As liquidity evaporated in the wake of the financial crisis, it has adjusted the way large asset managers hold and trade bonds, which then impacts the retail investors who put money into mutual and exchange-traded funds (read one institutional investor's story). Here's what's at stake:

Buyers are paying a premium to own liquid bonds

Investors who need to sell bonds in a hurry are finding less stable prices

A chaotic exit from the bond market could cause yields to spike and portfolio values to drop

These market shifts are set against the backdrop of a widespread fear that investors will leave the bond markets en masse as interest rates rise. Concerns about low bond-market liquidity mounted this summer as investors ditched bonds in what bond guru Jeffrey Gundlach has called a liquidation cycle (see what investors were saying at the time). The 10-year Treasury note yield spiked by more than 1.3 percentage points over the summer, briefly touching 3%, on concerns about a Federal Reserve wind down of its bond-buying stimulus program, which was announced last week. The benchmark note traded near 3% on Dec. 27.

The summer bond selloff propelled the corporate bond market to a brief correction characterized by wild movements in prices, though investment-grade prices rapidly recovered. If an event in the credit or rates market provokes another panicked rush to the exits, without the help of dealers as a cushion, it could strain the market and further exacerbate price swings. The fear is that what might have been a moderate selloff could cascade into a rout, sending costs on mortgages and corporate debt sky high.

“I think people have gotten too comfortable, nay complacent, with how this exit process works,” says Tom Murphy, sector leader for investment grade credit at Columbia Management. Investors have piled money into corporate bonds in the years since the financial crisis, but that could translate to chaos if sentiment reverses all at once.

But there’s always a silver lining, and the liquidity struggles facing the market may finally be heralding a broader discussion about whether and how the bond market can better meet the needs of investors. Buyers of debt would ideally like to be able to trade large blocks of bonds quickly and cheaply. The holy grail for many investors is something akin to the way equities trade: in high volumes with tight differentials between the price of a buyer and seller.

Fragmentation "The market is a mile wide and an inch deep.” — Will Rhode, director of fixed income, TABB Group.

That’s a difficult proposition, if not impossible. The corporate bond market is by nature fragmentary: while a company has one ticker symbol on a stock exchange, that same firm can have dozens of outstanding bonds, each with their own peculiarities. The wide range of differentiation allows companies easier capital markets access and it provides opportunities for investors who can parse the relative value of different issuances. It’s also at the heart of what makes it so hard to ensure a liquid market.

“The market is a mile wide and an inch deep,” says Will Rhode, director of fixed income at research firm TABB Group.

With liquidity making trading more difficult in the corporate bond market, there’s a growing recognition that a solution is needed, and that it may have to go beyond simply adjusting the point of interaction between dealers and investors. The whole market may need to evolve -- from standardizing the way bonds are issued to funneling the market toward a new trading structure.

The issue has long been top-of-mind among market insiders, but isn’t as widely discussed among the vast pool of investors who buy into the bond market for its perceived security. MarketWatch interviewed a range of corporate bond market participants in recent months to assess the origins of this shift, the reconsideration of trading strategies that it’s spurred among bond investors, and a possible path towards a better functioning bond market.