Richard Prager, head of global trading at BlackRock, was grinning even before he spoke. Appearing at a fixed-income technology conference in Midtown Manhattan, he had just spent two minutes giving a wonky assessment of the state of U.S. corporate debt markets to a packed auditorium of peers: the traders, strategists and portfolio managers who make up the bond trading world, and who were now listening to the man in charge of trading strategy at the world's largest asset management firm.

Ostensibly, Prager had spent those two minutes describing a chart, one noting the change over time in primary dealer corporate debt holdings. More accurately, he was telling a story. And just like any world-weary traveler telling the people back home about  his recent adventures, he was enjoying himself: gesturing, pausing for effect, and perking up in his seat as he approached the tale's dramatic denouement.

When he described dealer holdings "marching on up" prior to 2007, his left hand drew an imaginary ascending staircase. He then illustrated the "dramatic fall" of 2008 by bringing his right hand straight down, in a karate-chop motion, for added effect. With a furrowed brow of skepticism he spoke of "a sort of a feeble effort to resume the climb."

And then, as he held back a mischievous smirk while describing how the latest numbers did not jibe with the demand in the wider corporate bond market, he summed it all up: "Houston, we got a problem."

Prager is not the only market strategist describing the dynamic of the U.S. corporate bond market with grandiose historical references and histrionic body language. A current rally in the sprawling $7.74 trillion field for these securities, which are issued as debt by major American corporations, belies a great churning occurring just beneath the market's surface, Prager's noteworthy "problem."

"On Fire"

The first thing to know about U.S. corporate bonds, for anyone unfamiliar with the market, is that they're undergoing a monster rally at the moment. Since December 2011, yields on U.S. high-grade corporate bonds, which go down when prices rise (and vice versa), have gone down 13.57 percent, as tracked by the FINRA/Bloomberg Active Investment Grade US Corporate Bond Index. Another benchmark index, the Barclays Capital Investment Grade Corporate Bond Index, is near historically low yields.

"There's definitely a huge risk-on trade going on right now," said Justin Hoogendoorn, managing director of the strategic analytics group for U.S. fixed income at BMO Capital Markets.

Hoogendoorn, who sees "a good spot to take some gains" in certain parts of the market, such as cash flow-backed covered bonds, said "people have entered the year on a positive note."

He's not the only one singing the praises of corporates. Both JPMorgan Chase's and Bank of America's top bond strategists re-affirmed their bullish view of the corporate credit market this week, while Suki Mann, a London-based credit strategist at Société Générale, recently told The Telegraph that "the credit market's on fire."

On the flip side of the equation, companies have used the rally to issue substantial amounts of debt.

Some $79.6 billion in investment-grade corporate bonds were placed in January, less than what was placed during the same month last year, but still a substantial amount in a market where issuances have not broken the $800 billion yearly mark since 2007. Some $26 billion were then issued in each of the first two weeks of February, according to market data firm Dealogic.

A Peculiar Data Point

The laws of supply-and-demand suggest that, in a market with steady supply and rising prices, demand must be going up. But things are not so simple in the gargantuan market for corporate bonds, and indeed, an important indicator shows that some of the biggest financial institutions are dropping, not buying, the securities.

Data from the Federal Reserve Bank of New York on the corporate bond positions of the 21 primary dealers, the large financial institutions that are approved to trade bonds directly with the U.S. central bank, show that these financiers have been consistently reducing their corporate credit holdings since August 2011. The primary dealers have continued to do so in the face of the rally in corporates.

Since Aug. 10, 2011, when combined holdings stood at $103.7 billion, positions declined to $66.1 billion, a drop of 36.25 percent in less than six months. The big banks have been particularly keen on selling off their longer-term corporate bonds -- those with maturities more than a year away -- slashing their total holdings of these securities by 43.88 percent.

The primary dealer holdings drop is "one of the data points that I've been tracking for the past year or so," said Susanna Gibbons, a portfolio manager at RBC Global Asset Management, who leads the firm's credit research team for fixed income. "In terms of a technical environment, [the drop in primary dealer holdings] makes it actually very challenging for a portfolio manager."

Volcker, BASEL, "Unhappy Meetings"

The main reason for the drop in primary dealer holdings: regulatory uncertainty.

"The most significant factor is the Volcker rule. Most of the large dealers have significantly reduced their inventory because they don't know what the rule is going to look like," Gibbons said.

Proprietary trading in corporate bonds will be affected by the Volcker rule, once that regulation is finalized. The new regulation, which is still being hashed out by various regulatory bodies in Washington, is part of the implementation of the landmark Dodd-Frank financial reform law of 2010. Finalization, a contentious process that has taken longer than many in the industry had anticipated, is expected later this year. A secondary factor causing uncertainty is the upcoming implementation of new regulatory capital requirements, particularly those agreed to under the international BASEL III framework, which makes holding corporate bonds less attractive to dealers, at least from a risk-compliance perspective.

A credit strategist at a U.S.-based primary dealer, who spoke anonymously due to the sensitivity of the issue at hand, described "many unhappy meetings" between bank risk management officers (who make sure banks follow appropriate parameters when pursuing risky actions with the institution's assets) and fixed-income traders (a notoriously risk-loving bunch who manage those assets so as to maximize profits -- and their own year-end bonuses).

Massive Growth Elsewhere

With primary dealers exiting their prominent position in the market for corporates, the question of the day seems to be: Who's driving the rally?

According to a research note from Jeffrey Meli and Bradley Rogoff, two top credit strategists at Barclays Capital, a lot of the slack in demand is being picked up by mutual funds, whose investments in corporate credit have exploded over the past two years.

"Credit mutual funds, which typically allow investors daily liquidity, have grown massively," Meli and Rogoff wrote in the note last November.

Specifically, exchange-traded funds that hold corporate debt have multiplied, soaking up some of the corporate bond supply. "Flows into investment-grade corporates have remained pretty strong," Gibbons, the RBC portfolio manager, agreed.

Another dynamic that's driving demand is the manner in which many independent investment managers have shed their holdings of relatively exotic bond products: the synthetic instruments backed by credit card balances, home equity lines of credit, manufacturing debt, student loans and other liabilities known as "non-agency" securities in the industry.

Flush with cash from selling those assets, and seeing the rock-bottom yield and dubious promise of security offered by government bonds, portfolio managers are buying up corporates.

Illiquidity Premiums and Other Nasty Surprises

The result of this sea change:  Market-making duties are migrating from primary dealers, whose large "inventory" of corporate bonds made them a natural fit for this role, to other broker-dealers. The transition has not been easy, and liquidity - the ability for market participants to find willing counterparties in the market -- has suffered.

"The corporates market has become more illiquid than it was before the financial crash," said Steven Kellner, head of corporate bond strategies at Prudential Fixed Income, noting that "the illiquidity cuts both ways" by magnifying both rallies and slumps.

Kellner frames the current rally -- at least in part -- as "just too much cash chasing a much smaller amount of inventory."

Other market participants have noted that this lack of liquidity has been unevenly distributed, with the largest bond issues largely unaffected as the rest of the market becomes increasingly harder to trade.

As a result, many bonds trade with an "illiquidity premium."

The changes have also had other obvious effects.  Kellner, for example, notes the rise of a syndication pricing model, imported from the syndicated loan market, where highly in-demand offerings in new corporate bond issues undergo something akin to an auction. Corporate issuers are sometimes able to shave basis points off the yields they'd promised to pay on new debt, saving their corporations millions of dollars.

"It's not unusual to see offerings tighten 40 pips [basis points] from initial offerings. That's something that the corporate bond markets had never seen before the summer of 2011," Kellner said.

Good News (for People Who Like Bad News)

As with much else in the capital markets, it's hard to foresee who the winners and losers of the latest bond market dynamic will be. Issuers are clearly doing well at the moment, but they could suffer if volatile changes in the market distort pricing too much.

Traders are clearly not doing well, at least compared to their pre-2007 heyday, but they could see a recovery depending on what the final regulatory landscape looks like.

"It's difficult to understand exactly how it's going to work out. People seem to be at the stage of figuring out what it's going to mean," Hoogendoorn, the BMO strategist, said.

The drop in liquidity could also greatly affect newer market participants, as "it may be difficult and take time to construct a portfolio" from scratch, according to Kellner.

And of course, everything depends on the direction of benchmark interest rates, which are at the mercy of central bankers, not the open market.

"There's a terrific amount of cash around and there's a large amount of the investor base that is yield-sensitive," Kellner noted, suggesting that higher yields in the future could prompt rallies. "The pendulum swings back and forth."