(Recasts first paragraph to add interest rate risk)
NEW YORK, Nov 13 (Reuters) - Asset managers building big stakes in corporate bonds could be left hanging as banks cut back on providing liquidity, increasing the risk of chaotic selloffs should interest rates spike from record lows.
Big U.S. companies, including Verizon and Apple , have been selling record numbers of bonds to seemingly insatiable demand, as unprecedented stimulus from central bank bond purchases makes borrowing favorable for big corporations and as investors stretch for higher returns.
But fund managers say the strong primary debt sale activity is obscuring spotty liquidity in some secondary bond markets. Investors are struggling to buy and sell some corporate bonds, especially in large size, and trading costs can sometimes be volatile.
That's a challenge for buyside firms looking for ways to facilitate trading among each other and improve liquidity as they get bigger. Solutions have been hard to reach, and the fear is that if rates start to rise, selling could quickly escalate and the markets could see broad liquidity freezes as investors race for the exits.
"Right now the buyside is the provider of liquidity in the market," said Gregory Nassour, co-head of investment grade portfolio management at Vanguard. "As the sell side shrinks and the buy side gets bigger and bigger, that's going to be a long-term systemic issue."
Assets in U.S. funds that hold investment grade and high yield corporate debt have increased to around $820 billion, from $420 billion in October 2007, according to data from the Investment Company Institute.
But credit inventory by primary dealers, which also includes non-agency-backed mortgage debt, has declined to around $50 billion, from $233 billion in the same timeframe, according to data from the New York Federal Reserve.
Banks have pared holdings of corporate debt and mortgages as new rules make it more costly to hold riskier assets and discourage proprietary risk taking, and due to fears of rising rates. Other regulations make lower-risk Treasuries relatively more attractive as they can more easily be used to back derivatives, loans and other trades.
Corporate bonds are more vulnerable than some other bonds to liquidity freezes if rates spike. The broad swath of smaller, individual bond issues makes it harder to match buyers and sellers without intermediaries warehousing the bonds.
Yet corporates and emerging markets have become go-to markets for insurance companies, pension, mutual and other fund managers seeking higher yields as the Fed holds interest rates near record lows. This leaves them at greater risk of flight when rates turn.
Citigroup credit products strategist Matt King says that credit markets have turned into "tourist traps," with investors seeking yield for its own sake, rather than being fundamentally attracted by a bond. Banks and investors are also under greater pressure to mark bonds to market, which could exacerbate a selloff, he added.
"Central bank liquidity has been driving everything upward and making everyone a buyer rather than a seller," King said. "The market has become more homogeneous, and therefore the liquidity problems are all the more acute, and yet we haven't come up with any good solutions."
A sudden selloff this year from May through June was a taste of what could happen across fixed income if investors panic over rising rates.
Average total returns of investment grade corporates fell 6.16 percent and emerging markets fell 7.26 percent between May 2 and July 5, Barclays data shows. This coincided with the period when Federal Reserve Chairman Ben Bernanke raised fears that the Fed was closer to paring its $85 billion per month bond purchase program.
MANY IDEAS, FEW SOLUTIONS
To adapt, some bond fund managers say they need to act faster and be more adept at offering prices, instead of shopping between prices offered to them by dealers.
Many larger firms are increasingly using credit derivatives as alternatives or placeholders when they want to move quickly or gain different exposures than the cash markets allow. Fund managers are also turning to more index trades, rather than sourcing individual company bonds.
A recent survey by Greenwich Associates found that cash bonds fell to 65 percent of credit trading this year, down from 77 percent in 2012. Investment-grade credit derivatives index trades rose to 22 percent from 14 percent, Greenwich said.
Smaller fund managers are struggling the most with liquidity problems. Managers with more than $10 billion in assets increased trading volumes in investment grade credit by almost 30 percent in the last year, while those with less than $10 billion decreased trading by 23 percent, Greenwich found.
"The bank pullback has hit smaller investors hardest, with dealers forced to focus their limited time and money on only their biggest clients," said Kevin McPartland, an analyst at Greenwich.
At the same time, larger fund managers are having a harder time buying large blocks of bonds. BlackRock, the world's largest asset manager, has said that corporate bonds would benefit from greater standardization and more electronic trading to address shaky secondary liquidity.
But corporate bonds face unique issues. Companies issue debt at sporadic intervals to ensure they are not forced to repay all loans at the same time and few companies have enough debt to standardize into large and liquid tranches. Those who do rarely "re-issue" bonds, that is, sell additional amounts in an existing issue the way the U.S. Treasury does.
Fund managers have formed several groups to try to come up with solutions to ease liquidity problems. More firms are also launching exchange-traded funds that may draw in more retail investors.
Credit and interest rate derivatives are slowly migrating to electronic trading platforms meant to draw in new entrants, increase liquidity and help fund managers trade with one another. It is hoped that greater adaption of electronic derivatives trading will in turn help boost that of bonds.
Derivatives have had a boost from regulatory mandates to trade electronically and standardized contracts make them easier to trade that way. As investors shift to these platforms they may also decide to trade bonds there too, especially managers that pair cash and derivatives trades.
"The new swaps rules are likely to also encourage more investors to trade electronically in cash markets, especially for basis trades between the different markets," said Greenwich's McPartland.
(Editing by Chris Reese and Dan Grebler)