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The Evolution of Corporate Bond Liquidity: The Good, the Bad, and the Ugly
The Institutional Investor Sponsored Guide to Fixed-Income Investing
By David Cushing, CFA, Director of Global Trading and Michael Taylor, Associate Director of Fixed-Income Product Management
Post-crisis shrinkage in dealer inventories, together with a significant increase in market size, has fueled concerns about the liquidity of secondary markets in corporate bonds. Recent market volatility and large-scale bond fund flows have only added to these worries. Our research on this issue has revealed much about the current state of liquidity in these markets and where it may be headed.
Banks are increasingly acting solely as brokers in
secondary-market transactions, rather than dealing from their own inventory.
Secondary-market liquidity has diminished, but there is no
evidence of a more serious drop in liquidity recently.
However, there has been a sharp decline in the breadth and
depth of liquidity; portfolio size matters.
Moreover, liquidity conditions have become more sensitive
to market disruptions and spread-widening events.
Why has secondary-market liquidity in corporate bonds declined?
Industry consolidation and balance-sheet delevering, partly
driven by post-crisis regulatory initiatives, have made banks less willing to
purchase corporate bonds in the secondary market and to hold those securities
on their balance sheets as inventory until a buyer is found. As a result,
inventories of corporate bonds have fallen to a fraction of their pre-crisis
levels.
This shrinkage has prompted understandable worries on the
part of investors. After all, secondary-market liquidity is the grease that
allows any market to function smoothly. Our analysis suggests that the decline in
secondary-market liquidity and the resulting increase in liquidity risk for
investors is real, but that this trend has not accelerated recently.
Transaction costs
have remained stable in normal market conditions
Even as bank inventories of corporate bonds have shrunk
since the crisis, market activity has risen. Secondary-market trading volumes,
as measured by TRACE, have risen by over 30% since 2007 and have more than
doubled since their lows in the depths of the global financial crisis. However,
the size of the US corporate bond market has also doubled since 2007. This has
caused a steady drop in turnover, or the share of outstanding corporate bonds
that trade in the secondary market. This trend is not unique to corporate
bonds; turnover in US Treasuries has plummeted even more sharply, to below 4%
recently versus almost 13% in 2007. However, despite the decline in turnover
relative to pre-crisis levels, we have seen no evidence of a more recent,
precipitous drop in secondary-market liquidity.
This view is reinforced by the Barclays Liquidity Cost Score
(LCS), a measure of the round-trip transaction cost of executing a standard
institutional transaction in the secondary market. This data indicates that
transaction costs for US investment-grade corporate bonds are currently among
the lowest since 2007 though still meaningfully higher than in that year
(Figure 1). High-yield corporates show a similar pattern. The LCS estimates
transaction costs rather than liquidity, but the two are often inversely
correlated, since transaction costs are typically higher for less liquid
securities.
Liquidity has become more sensitive to credit-spread movements
In periods of tightening credit spreads, when corporate
bonds are performing well, liquidity conditions typically have been benign. In
fact, buyers have often been easier to find than sellers. But in periods of
volatility that typically accompany credit-spread widening, transaction costs
can rise significantly for both investment-grade and high-yield corporates,
suggesting constrained liquidity.
Many market participants fear there could be a serious
dislocation in the corporate bond markets should investors seek to redeem their
holdings en masse. This concern is especially pressing for investors with large
holdings of corporates, since the speed with which a portfolio can be
liquidated now decreases rapidly with increasing size.
Wellington Managements proprietary Liquidity Evaluation
Framework (LiEF®) creates a point-in-time estimate of a portfolios liquidity,
drawing on issue-specific characteristics and historical patterns of trading
activity. Using LiEF, we estimate that over 80% of a US$1 billion
investment-grade corporate bond portfolio that resembles a representative corporate-bond
benchmark could be liquidated in a typical week and 100% within a month.
However, the speed with which a portfolio can be liquidated slows sharply as
its size increases (Figure 2).
Liquidity has become
more unevenly distributed
In addition to the question of market depth, there is also the question of breadth: Can bonds with similar risk profiles be traded similarly? The short answer is no. The difference in liquidity between the most liquid 20% of the US corporate bond market and the rest of the market is at its highest in the past five years, albeit still well below pre-crisis levels (Figure 3).
Investors have long received an illiquidity premium in
yield for holding off-the-run versus on-the-run bonds. Our research indicates
that the illiquidity premium has halved over the past two years amid low yields
and generally low market volatility, suggesting that this type of environment
may not be the best time to exploit the illiquidity premium. In fact, it might
be better to hold more liquid corporate bonds in stable markets, and seek an
illiquidity premium in more volatile periods when the extra return for assuming
liquidity risk is more attractive.
Implications for investors
The better
liquidity of on-the-run corporate bonds suggests that active managers and
high-turnover managers, in particular should focus portfolios on more
recently issued securities to improve liquidity and reduce transaction costs.
Active
managers again, high-turnover managers, in particular need to carefully
manage their corporate bond capacity to ensure secondary-market transaction
costs do not erode their ability to meet investors performance objectives.
Investors
planning to rebalance the asset allocation of their overall portfolios should
allow more time to do so. This will provide more time to better match buyers
and sellers in the secondary market, and allows for the use of primary-market
new issuance as a source of supply to replace bank inventories.
Investors
should carefully consider timing when shifting assets into or out of corporate
bonds regardless of whether the portfolios involved are exchange-traded
funds, mutual funds, or separate-account mandates as both the time required
to transition and the transaction costs involved may be significantly higher
during volatile market environments, when the directional nature of
secondary-market liquidity may not be in their favor.