Buy-side fixed income traders are perhaps not ready for a world without a sell-side.

A recent trend taking shape in the U.S. capital markets is a more independent buy-side. BlackRock, the world’s largest asset manager with approximately $3 trillion under management has already stated plans to internalize trading within equities to reduce transaction fees. It’s a feat, regulators-permitting, that would only be possible at a firm of BlackRock’s size given that inventory wouldn’t be a problem.

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Even though such a move would cause a headache for rule-making regulators, it’s partly due to regulation that’s causing buy-siders to veer off independently in the first place: namely, the Volcker Rule, which is attempting to squeeze out inventory levels at major investment banks and brokerage houses.

“We have some concerns regarding the scope of the rule – in particular, the definitions of covered funds and application of the requirements to certain affiliates,” said a T. Rowe Price spokesperson. “We are concerned about the impact of the rule on legitimate market making activity and capital markets’ liquidity – features that are critical to our ability to invest for our clients.”

Liquidity has been on-going imperative for bond traders, especially those going down the credit scale to reach for yield in a barely-there yield environment.

“These regulatory changes appear to be causing reluctance on the part of broker-dealers to commit risk capital to support bond inventories at the same level as they have in the past,” said Steven Huber, fixed income portfolio manager at T. Rowe Price. Huber is head of portfolio strategy for global multi-sector bond, core, and core plus strategies.

For high-yield bond traders, where liquidity is already scarce, new regulation will especially hit hard. Huber observed that secondary market liquidity has “already diminished.”

At year-end 2011, broker-dealer inventories of corporate securities were approximately $46 billion, down 80% from pre-crisis levels of $235 billion in late 2007, according to Bloomberg data.

As market makers have drawn down inventories, liquidity has declined. Huber said. As result, the key is to staying liquid has become to stay within large issues, where most of the trading activity has occurred in recent times of high volatility, according to Huber.

Those who are accessing high-yield exposure through passive vehicles, such as increasingly-popular ETFs (exchange traded funds) need to especially remain liquid.
“High yield ETFs often attract tactical cash flows that can reverse course rapidly based on prevailing macro trends and investor sentiment,” Huber said in a statement. “Because of unpredictable flows, ETF managers must maintain sizable positions in large, liquid bonds that can be sold quickly to meet redemptions.”

A stagnant trading environment is here to stay in the near-term, according to Huber. The threat is greatest for those that take long-term views and will eventually struggle to exit positions when valuations drop.

To navigate through such challenging markets, Huber is practicing “balancing liquidity and credit exposure.”

“Global Treasurys and mortgage-backed securities will serve as a liquidity cushion, and despite changing technical factors, we continue to see long-term value, especially in the high yield market,” Huber said.