Why Are Primary Dealers Are Liquidating Corporate Bonds At An Unprecedented Pace

By now it is common knowledge that over the past two years the primary source of stock buying have been corporations themselves (recall Goldman's admission that "buybacks have been the largest source of overall US equity demand in recent years") with two consecutive years of near record stock repurchases. However, now that a December rate hike appears practically certain following the "pristine" October jobs report, suddenly the question is whether the recent strong flows into bond funds will continue, and generously fund ongoing repurchase activity.

The latest fund flow report from BofA puts this into perspective

The increase in interest rates is starting to impact US mutual fund and ETF flows. Hence, the inflow into the all fixed income category declined to +$0.96bn this past week (ending on October 4th) from a +$2.80bn inflow the week before... Outflows from government funds accelerated further to -$2.43bn this past week from -$1.73bn and -$1.00bn in the prior two weeks, respectively.

But more concerning for corporations than even fund flows, which will surely see even bigger outflows now that both yields are spreads are set to blow out making debt issuance far less attractive to corporations whose cash flows continue to deteriorate, is what the NY Fed reported as activity by Primary Dealer, i.e., the most connected, "smartest people in the room" who indirectly execute the Fed's actions in the public markets, in the most recent week.

As the charts below show, the Primary Dealers aren't waiting for the December announcement to express how they feel about their holdings of both Investment Grade and Junk Bond (mostly in the longer, 5-10Y, 10Y+ maturity buckets where duration risk is highest).

Indeed, as of the week ended October 28, Primary Dealer corporate holdings tumbled across both IG and HY, plunging to the lowest level in years in what can only be called a rapid liquidation of all duration risk.

Investment Grade Bonds:


And Junk Bonds:


Why would dealers be liquidating their corporate bond portfolios at such a fast pace?

For junk, the obvious answer is that with ongoing concerns around rising leverage, not to mention yields being dragged higher by the ongoing pain in the energy sector, this may be merely a proactive move ahead of even more selling.

But for IG the answer is less clear, and the selling likely suggests fears that any December rate hike will see spreads blow out even further, and as a result dealers are cutting their exposure ahead of December.

Whatever the answer keep a close eye on this series: if Dealer net positions turn negative it will mean that the corporate buyback door is about to slam shut in a hurry as others begin immitating the 'smartest and most connected traders in the room', depriving corporations of their biggest source of stok buyback "dry powder." In fact, taken to its extreme, if companies suddenly find it problematic to raise capital using debt, we may soon enter that phase of the corporate cycle best known by a spike in equity issuance, whose impact on stock price is just the opposite to that of buybacks.

Source: NY Fed