Damon sounded the alarm on corporate bond liquidity: Low spreads mask the risk of a collapse, and the Federal Reserve may need to intervene again to rescue the market.

Notice that as liquidity providers are increasingly being replaced by liquidity takers, corporate bonds are facing the risk of sharp declines. JPMorgan CEO Jamie Dimon warned that the current situation bears similarities to the era before the 2008 financial crisis. His concerns are not unfounded, but investors may not be aware of this if they only look at credit spreads (currently nearing historic lows). Dimon admitted at the annual investor update meeting: "When everyone is making money easily, performing well... you might feel stupid, but it feels great." He continued, "Then when I think about all the factors that are happening, I take a deep breath and tell myself: 'Be careful!' Unfortunately, we did see almost the same situation in 2005, 2006, and 2007 - everything was going well, everyone was making big profits. I see some people doing silly things. They are just doing stupid things to create net interest income." While credit spreads are at historic lows, there is limited room for them to further widen in the face of downside risks. Banks and broker-dealers used to be the largest "price makers" in the corporate bond market, but their footprint has significantly reduced; meanwhile, "price takers" - most notably exchange-traded funds (ETFs) - are rapidly increasing in size. Currently, the size of corporate bonds held by ETFs is about 25% more than that of U.S. banks (about $250 billion). In fact, since 2024, ETFs have been the only major sector to increase their holdings in a circulation size of approximately $16 trillion. Other sectors that may provide liquidity or seek opportunities to buy after price declines - such as banks, pension funds, and foreign investors - have reduced their market participation. Banks nearly "escaped" the corporate bond market after the financial crisis. This is due to the Volcker Rule restricting proprietary trading activities, as well as enhanced liquidity regulations requiring banks to hold more high-quality liquid assets (HQLA), thereby increasing the balance sheet costs of holding corporate bonds. Although the total circulation of corporate bonds has increased by 70%, the size of corporate bonds held by broker-dealers/traders has decreased significantly from over $300 billion during the global financial crisis to currently between $70 billion and $80 billion. The amount of corporate debt held by broker-dealers is decreasing Ten years ago, the size of corporate bonds held by traders and broker-dealers was about six times the daily trading volume, whereas today it is barely equivalent to the daily trading volume. The $1.25 trillion held by ETFs is about 25 times the trader holdings. In addition, the corporate bond inventory of primary dealers - the net positions between repurchase agreements and reverse repurchase agreements - has recently dropped to near-zero levels. Why is this now a problem? While this liquidity mismatch is occurring, bond funds are likely increasing their exposure to corporate bonds (even though their exposure relative to the total amount has slightly decreased). The surge in U.S. bond issuance in recent years has pushed down composite index returns, prompting funds to buy more high-yield corporate bonds to boost performance. The rise of basis trading leaves a clue. The additional exposure of funds to corporate bonds leaves their duration relatively low compared to the composite index. To address this issue, they buy bond futures; while hedge funds are willing to sell futures, exploiting the basis between futures and cash bonds to earn "risk-free" profits (which are not actually risk-free). The increase in the exposure of bond funds to corporate bonds also suggests a rising sensitivity to corporate bond returns, although the weight of such bonds in the composite index has remained stable since 2022. While credit spreads are tightening, there is no shortage of catalysts that could trigger corporate bond sell-offs. Take the $1.8 trillion private credit market, for example. As a well-known sector with extremely low transparency, there are signs that problems in the industry are brewing following the recent sell-off of software stocks this year. Business development companies (BDCs) occupy about 20% of the private credit market, with their largest single exposure being in the tech industry, with the majority in software companies. These companies were once seen as attractive borrowers because they had high profit margins and monopolistic or oligopolistic potential in niche areas. However, with the recent improvement in AI-based coding capabilities and lower barriers to entry for new companies, SaaS businesses may become commoditized, shaking the above view. Blue Owl Capital is possibly the "canary in the coal mine". The company has suspended redemptions for one fund, only returning funds when market conditions are favorable for asset disposal. Similar to bond ETFs, this issue at the core is another liquidity mismatch. The funds involved are sold to retail investors, offering quarterly redemptions, but most private credit is held by institutional investors with lock-up periods ranging from four to six years (the average loan maturity). You don't need to be a financial prophet to see that this will cause problems. However, this has not stopped the modest growth of private credit ETFs, with total market value increasing from almost zero to between $1.5 billion and $2 billion in just two years. Any turmoil in the private credit market will soon spill over to the public credit market through bank loans. Since 2024, U.S. banks have significantly increased their claims on non-bank financial institutions. According to data from the Bank for International Settlements (BIS), as of July 2025, about 14% of the $2 trillion in such outstanding loans is lent to BDCs. Public credit spreads are also facing pressure from massive investments in AI infrastructure. With the rise in individual stock volatility, they face a brutal wake-up call. Company equity is akin to perpetually bullish options on a company's debt repayment ability. When simulating credit risk, investors and traders often use index stock volatility as an input. However, if index correlations (currently quite low) were to increase, index volatility could jump even higher and better reflect the increase in individual stock volatility. Individual stock volatility is on the rise Therefore, it is not difficult to imagine the scenario Dimon described as a "deterioration" in the credit market: this could trigger a rush to exit for overexposed funds and other holders hoping to avoid heavy losses. Due to the lack of stabilizing "price makers" in a downturn, a sell-off could potentially turn into a meltdown. The Federal Reserve was willing to buy high-yield corporate bonds in an unprecedented manner in 2020; in the future, it may have to intervene again.