Thursday, October 29, 2015

Corporate bond liquidity - should we be worried?

The New York Fed economic blog has written an informative series on corporate bonds liquidity. It shows that by some simple measures liquidity has returned or improved relative to pre-Crisis levels; nevertheless, we think there are significant changes in corporate bond trading that have not been fully realized or fully discussed by the New York Fed. The ways of doing business in corporate bond trading have significantly changed over the last few years.  Their research work does not fully address these structural changes which is impacting the way investors trade in corporates. Although liquidity does not seem to be a problem in corporate trading, we still are in a period of strong demand for bonds as the reach for yield continues. We will have to see what liquidity looks like when there is a change in longer-term asset class demand.

The current concern about liquidity in corporates is simple. Dealers have been holding less in inventory, yet there has been a significant increase in the amount of bonds being issued. There has not been a significant amount of global deleveraging so the debt outstanding is still high. Most expectations would say that the cost of immediacy when there is less dealer inventory should be impaired. If that is not the case, the cost of search for finding liquidity has to have gone down or dealers have gotten much better at their jobs.

Trading volume in corporate bonds has increased about 50% since the crisis, and is about 25% higher than the pre-crisis trading volumes. More trading is going on given the increase in the new supply. The composition of trading has also changed. The average trade size is down 25% but the number of trades have almost doubled, so the volume increase is coming from more smaller transactions. The bid-ask spreads have fallen to their lowest levels, but that might be expected if the risk of trading any bond is lower since the trade is smaller. What the research has found is that the price impact of trading has declined which suggest that the market is in good shape. 

There may be illiquidity jumps, but the general measured conclusion  by the Fed is that bond liquidity is ample and better than any time in the history of the corporate credit markets. Liquidity risk will move with changes in volatility, but even here the Fed can conclude that we are in much better liquidity shape than in the period before the Crisis.

So should we be worried? There seems to be an active deep market that is better serving investors than before the Crisis regardless of the changes in regulation,  but there have still been some very big changes in how business is getting done.

The strutural change in corporate bond trading is very simple - dealers are falling out, matching engines and requests for quotes are in. Although dealer inventories have fallen relative to the debt outstanding and the amount of trading, alarm bells have not occurred because there have been changes in the way business is done. There are a growing number of platforms and matching engines in corporate bonds. Some have failed. Others have not reached critical mass. There is no single "exchange" or dominant player, but electronic matching, request for quote type systems, have moved from single digit to almost one third of the trading. Dealers are not adverse to this if they can facilitate trading and use less capital. The electronic trading of equities, futures, currencies and cash Treasuries is coming to corporate bonds and this may be a savior to the market.

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