For The First Time Ever, Corporate Bond Inventories Turn “Negative” – What This Means

As we noted previously, for the first time ever,
 primary dealers’ corporate bond inventories have turned unprecedentedly negative. While in the short-term Goldman believes this inventory drawdown is probably a by-product of strong customer demand, they are far more cautious longer-term, warning that the “usual suspects” are not sufficient to account for the striking magnitude of inventory declines… and are increasingly of the view that “the tide is going out” on corporate bond market liquidity implying wider spreads and thus higher costs of funding to compensate for the reduction is risk-taking capacity.

As Goldman Sachs’ Charlie Himmelberg notes,

Following several weeks of sharp declines, dealer inventories of long-term IG bonds and HY bonds have turned negative for the first time since the NY Fed started reporting corporates separate from non-agency mortgage MBS. While inventory levels are often negative for Treasuries, this is the first time in the available data that corporate bond inventories have ever turned negative (detailed data on corporates go back only a few years, but broader aggregates of corporates plus non-agency MBS have never gotten remotely close to zero).

To some degree, the inventory drawdown is probably a by-product of strong customer demand. The rally in credit spreads since Oct. 2 was helped in part by a resumption of mutual fund inflows (especially in HY) at a time when dealer inventories were already substantially depleted. In addition, HY new issue volumes – which drive dealer inventory holdings because they drive secondary trading volume — have cooled somewhat over the past month as wider spread levels helped to deter issuers.

But these “usual suspects” are not sufficient to account for the striking magnitude of inventory declines. Exhibit 1 below shows how weekly dealer inventories for investment grade bonds have evolved over the past 2.5 years, and compares this to the changes implied by a simple model that estimates the effects of new issue volumes and mutual fund inflows (both ETFs and open-end funds) estimated on data through June 1, 2015. The plot shows that model-implied inventory levels have, in fact, been declining since early August. But, in fact, as the chart also shows, the model gives a very poor fit over the full sample period (R2=14%), and an analogous model for HY bonds is even worse (R2=9%). Whatever is driving the decline in corporate bond inventories, it is not visible in the (observable) changes in market conditions used here.