3 separate unique markets within credit

I've long espoused a view that there are 3 separate and distinct markets within the credit space.  One can be rallying like there's no tomorrow while the other is moribund.  The next day, the complete opposite can occur.  There does not seem to be any lead or lag effect.  

Secondary cash bonds - this is the 'old fashioned' market.  You can watch the volume on TRACE (mentioned in an earlier post).  Years ago, before the brokers were nationalized, brokers used to use their firm's capital to take positions and make markets.  While they still do this (principal trading), the capital allocated to it is down by 70-80%.  The margins are now razor thin due to the advent of TRACE.  Now the 'market' is made up largely of smaller regional dealers and banks that have little or no capital.  If the dealers can't make money, they won't trade bonds.  Unfortunately, these are the securities that are held by the large money managers....and their liquidity needs have NOT dropped 70-80%.  In fact, they've largely increased.  Thus the 'liquidity crisis'.  

New issue bonds - The IPO market in debt.  Recently the supply has been enormous, especially if you factor in FDIC backed debt.  Here's the conundrum....this supply has been eagerly gobbled up by investors....while secondary spread have languished.  This was the story for most of 2007 and 2008.  If you owned secondary bonds in XYZ corp, and they brought a new issue, the spreads on your secondary bonds would widen 50 basis points.  Also, you have 'liquidity' in new issue bonds...if you want $100 million worth of bonds, you're likely to get it.  Yes, it's unidirectional liquidity.  

CDS - this is where the bulk of the liquidity in the market exists.  It has been shifting into this market for the last 3-4 years.  This is where the brokers provide the most (relative) liquidity to their clients and other brokers.  Why this market?  Well, 2 reasons...one, there is no TRACE so no one can watch exactly where they are buying and selling risk.  Opaque markets provide profits.  Two, there risk capital weightings and balance sheet needs are lower in this market....higher ROE.  

You can follow the gap between the first and third markets I mentioned here in the 'negative basis'.  Currently, cash bonds are ~250 basis points cheap to CDS.  In theory, this is a risk free arbitrage....but only when it collapses and it hasn't been near flat/0 in a long long time.  This is one huge driver of the losses in the credit hedge fund space. 

Remember, don't assume that a healthy new issue market portends demand for your secondary bonds.  Also, just because CDX (the CDS basket index) is rallying doesn't mean that your cash bonds are following suit.