Individual investors, who hold more sway over the corporate bondmarket than ever, are allocating the least amount of cash this yearto U.S. high-yield mutual funds in a signal that sentiment may beshifting.

Speculative-grade bond funds reported net inflows of $75 millionthrough April 16, the lowest since a monthly outflow of $9.1million in December, according to EPFR Global data. U.S. mutualfunds reported an unprecedented $698.3 billion of corporate bondassets at the end of February, from $327.9 billion in 2008, datacompiled by the Investment Company Institute show.

Consumers have seized unprecedented control of the market forcompany debt as Federal Reserve data show ownership falling toalmost a 10-year low and as trading as a portion of total bondsoutstanding declines worldwide. Concern is mounting that a reversalof the stampede into the securities would undermine a market that'sgained 54 percent since the end of 2008, Bank of America MerrillLynch index data show.

“You just have to pray the funds' investors never want to sellall at once,” said Matt King, global head of credit strategy atCitigroup Inc. in London. “You've got the classic combination ofpromised instant liquidity and illiquid underlying assets.”

The volume of junk-bond inflows is falling from a peak of $5.5billion in February, with investors funneling less than half ofthat into funds the following month, EPFR data show.Speculative-grade bonds have gained 0.08 percent this month afteradvancing 5.1 percent this year through March 31, according to Bankof America Merrill Lynch index data.

“In the last week or so I've sensed a higher degree ofnervousness in the market,” said Bonnie Baha, head of the globaldeveloped credit group at DoubleLine Capital LP in Los Angeles,where she helps oversee $32 billion.

While global debt issuance has soared since the 2008 financialcrisis as companies reacted to the withdrawal of bank credit byrushing to issue bonds, proportional trading volumes have dwindled.Bond sales peaked at $3.9 trillion globally in 2009, an increase of$1.1 trillion from the previous year, and have held at about $3.2trillion annually since then, data compiled by Bloomberg show.

Securities equivalent to about 96 percent of the outstandingmarket are traded in the U.S. every 12 months, down from about 180percent at the peak in 2005, Citigroup data show.

Default Swaps Rise

Elsewhere in credit markets, a benchmark gauge of U.S. companycredit risk increased for a second day, with the Markit CDX NorthAmerica Investment Grade Index, which investors use to hedgeagainst losses or to speculate on creditworthiness, climbing 1.2basis points to a mid-price of 100.6 basis points as of 12:18 p.m.in New York, according to prices compiled by Bloomberg.

The index typically rises as investor confidence deterioratesand falls as it improves. Credit-default swaps pay the buyer facevalue if a borrower fails to meet its obligations, less the valueof the defaulted debt. A basis point equals $1,000 annually on acontract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of bondmarket stress, rose 0.69 basis point to 29.88 basis points as of12:19 p.m. in New York. The gauge widens when investors seek theperceived safety of government securities and narrows when theyfavor assets such as corporate bonds.

Bonds of Chesapeake Energy Corp. are the most actively tradedU.S. corporate securities by dealers today, with 153 trades of $1million or more as of 12:19 p.m. in New York, according to Trace,the bond-price reporting system of the Financial IndustryRegulatory Authority.

Bond trading has become more difficult because investment bankswon't commit so much capital to hold the securities on their booksas regulations on risk-taking loom and financial companies remainconcerned that Europe's sovereign-debt crisis may escalate.

Dealers that are authorized to buy Treasuries directly from thegovernment have reduced corporate debt holdings to $45.6 billionfrom the $235 billion they held at the peak in October 2007,according to Fed data compiled by Bloomberg.

“The quickest way to create liquidity when you have theseoutflows is to sell what you can,” not necessarily what you wantto, Baha said. “If everyone heads for the exits at the same time,given the poor liquidity that we're already seeing in the market,you're going to see some incredibly volatile pricing moves.”

Holdings dropped to $40.4 billion on Feb. 22, the lowest sinceJune 2002, according to the data.

Liquidity Drops

“Each and every investment bank has significantly reduced thecapital it's prepared to commit to taking risk in recent years,”said Constantinos Antoniades, the founder of Vega-Chi Ltd. inLondon, which operates an electronic trading system for high-yieldand convertible bonds.

Credit markets can freeze and prices plunge, as happened in2008. From the end of August to Dec. 15, the Barclays Capital HighYield Market Value index plunged 44 percent, before starting torally at the end of that year.

“Liquidity, even for the biggest clients, has droppeddramatically,” said Peter Tchir, founder of TF Market Advisors inNew York.

The trend of volume ebbing is global. In euro- andpound-denominated debt, 12-monthly turnover has slipped to about 40percent of the market from as much as 120 percent in 2004,according to New York-based Citigroup.

As trading volumes decline, there are few signs that buysidefirms and brokerages can swiftly replace the volume that large WallStreet banks have withdrawn from the market.

“One way to ensure there is liquidity in the market and there isno risk of a shut-down at times of market stress, is to reducereliance on investment bank dealer desks,” Antoniades said.

Agency brokers, dealers that seek to match buyers and sellers ofsecurities without holding them on their own books, as well asindependent electronic platforms that allow clients to enter buyand sell orders without going through an intermediary are trying togain ground.

Over time, electronic trading systems, combined withclearinghouses for credit derivatives and new instruments such asexchange-traded funds that track bond indexes, will help replacethe market makers, according to Tchir.

Bypass Banks

BlackRock Inc., the world's largest money manager, said April 12it plans to start a bond-trading system that will help investors tobypass investment banks. The firm, which hopes to attractinstitutional investors including sovereign wealth funds andinsurers to the platform.

For now, fund managers are taking preemptive measures to addressshrinking secondary market volumes.

Because it is hard to trade, managers hold on to cash to meetredemptions to avoid having to sell into a rout, said Ashish Shah,who helps oversee about $420 billion as head of global creditinvestments at AllianceBernstein LP in New York.

The possibility that the market might seize is “a legitimateconcern but portfolio managers have that concern and manage withthat in mind,” he said in a telephone interview.

Bloomberg News

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