The Deteriorating Bond Market

Accrued Interest has a great blog entry today on the implications of the big secular shift in the bond market, away from hedge-fund-driven leveraged relative-value plays and towards long-term real-money investing. No longer is it likely that arbitrages even of spreads over 100bp are likely to be jumped on:

Take something simple like Fannie Mae 5-year bullet bonds. Should have a very small spread versus Treasuries given the government backing of the GSEs, but instead the spread is currently around 1.45%. It seems like an arbitrage.
But in order for an actual arbitrager to realize a decent IRR on the trade, it probably needs to be leveraged 20x or so. Now maybe one can actually get that amount of leverage versus Agency collateral, but what happens if the trade initially goes against you? The potential margin calls would kill you. Its a difficult arbitrage to actually realize.

The consequence is that the bond market in general -- and even formerly-liquid instruments like the 30-year Treasury bond -- is going to be "permanently less liquid", to the point at which new long-bond issuance can drive prices down 2.5% in one day. As a result, there will be a 3-5% "tax" on anybody wanting to sell their bonds in the secondary market, which will give most investors a very strong incentive to hold onto their bonds to maturity.

And as a result of that, no one's going to buy riskier bonds with any expectation that they'll be able to sell the things should the credit start deteriorating.

In other words, the bond market is beginning to look very much like the loan market. Which has to be a bad thing, from a macroeconomic perspective: the liquidity of the bond market is one of the few financial innovations to have an unambiguously positive effect on corporate finance in recent decades.