(Reuters) -- Morgan Stanley this week cut staff covering short-term credit and regional broker-dealers, after a quarter in which the bank posted a 42 percent drop in bond trading, several sources told Reuters.

The sources blamed the shakeup at the No. 6 U.S. bank by assets on tougher capital rules, mounting competition from faster and cheaper trading on electronic systems and expectations that the Federal Reserve will raise U.S. interest rates next week for the first time in nearly a decade.

The decision to downsize followed one of Morgan Stanley's slowest quarters for bond trading since the global credit crunch.

The bank has been focused on improving profitability within fixed income and has been scaling back businesses that miss those metrics, the sources said.

Morgan Stanley's short-term credit desk, including its commercial paper business, has seen extensive cutbacks, they said.

Morgan Stanley has also significantly reduced the number of bond sales people who cover smaller, regional broker-dealers, they added, although the bank will continue to cover these types of clients.

A Morgan Stanley spokesman declined to comment on the layoffs.

Traders and fund managers interviewed by Reuters said Morgan Stanley's move is hardly a surprise as tougher capital rules, domestic and abroad, have made it less profitable to trade Treasuries, agency debt, corporate bonds and mortgage-backed securities.

These rules, intended to curb excessive risk-taking, have also raised the cost for Morgan Stanley and other top Wall Street firms to borrow in the short-term, wholesale funding markets including the repurchase agreement (repo) market.

With the Fed widely expected to hike rates next week, the daily cost for trading will likely go up further.

In addition, the proliferation of electronic systems and high-frequency trading firms has eroded Morgan Stanley and other Wall Street dealers' dominance in market-making the bond market.

This year, electronic trading platforms are on track to capture 20 percent of U.S. investment-grade bond trading volume, a 25 percent rise from year earlier, according to research firm Greenwich Associates.

As competition from anonymous systems has grown, the need to pitch blocks of bonds on the phone or emails to clients has decreased.

(Additional reporting by Elizabeth Dilts in New York; Editing by David Gregorio)