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 Management’s proprietary Liquidity Evaluation Framework (LiEF®) creates a point-in-time estimate of a portfolio’s 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.