Corporate Bonds: What if No One Wants to Buy?
The efforts to strengthen the financial system led to lower and more volatile liquidity in the corporate bond markets. Investors might find themselves in a situation where no one will buy. To properly manage expectations, and to be able to plan ahead, investors need to understand this new landscape.
Since the financial crisis in 2008, rules on financial institutions have tightened to improve the stability of the financial system. Therefore, banks and dealers have strengthened their financial profiles and limited risky capital market activities. This structural change is especially important to bond markets as they depend on intermediaries willing to warehouse risk and facilitate trading activity. As a number of studies suggest, liquidity in bond markets has decreased since 2008. This could potentially lead to more severe price swings.
Fixed Income Environment
Compared to equities, the fixed income market relies more on dealers and over-the-counter structures, which makes it more decentralized and dependent on functioning intermediaries. Further, the market for corporate debt is much more fragmented than the market for equities as companies usually offer very few classes of equity, but a large number of different debt instruments. Within the bond market, different classes of debt exhibit different liquidity characteristics:
- Government bonds are seen as more liquid than corporate bonds. They issue in larger lots, have fewer maturities and usually do not add exotic features to their debt.
- The corporate bond market is much more fragmented and thus shallower. Moreover, different risk segments exhibit different liquidity traits. Investment-grade debt is usually more liquid, while high-yield and emerging-market debt are perceived as less liquid.
Declining Liquidity Raises Awareness
A number of recent influential publications state that liquidity in debt markets has shown a diverging trend since the financial crisis in 2008/2009: global market activity is concentrated more in the most liquid securities like sovereign bonds, and less in riskier securities such as corporate bonds. This trend suggests an increased fragility of the latter. The International Capital Market Association, conducted a series of interviews to analyze the topic from a market perspective. The study "The Current State and Future Evolution of the European Investment Grade Corporate Bond Secondary Market" finds that liquidity in secondary European corporate bond markets declined. Interviewees described the decline ranging from "significantly" to "completely." A survey of large banks published by the European Central Bank in January 2015 focused on Euro-denominated markets and arrived at similar results. More banks reported that their market-making activities for credit securities had decreased during 2014 rather than increased, and a further decrease is expected in 2015.
Regulatory Tightening a Driver
Increased regulation in the financial sector resulted in the decline in corporate bond market. Since the financial crisis in 2008 (which revealed a number of shortcomings of financial regulation) the regulatory framework has been improved and tightened, which led to a reduction of market-making and trading activities by banks. As the amount of equity needed to hold against risky positions increased, market-making activities became less profitable. The newly introduced Liquidity Coverage Ratio and Leverage Ratio made banks hold more liquid securities, reduce high-volume/low margin business such as trading activities, and limit their reliance on short-term funding. Banks also have cut proprietary trading which has been a source of liquidity. As a result, banks and dealers have reduced their fixed income trading activities since 2008 as well as their ability to warehouse risk and facilitate capital market activities.
Worst Case Scenario
So far, the decline in bond market liquidity has not caused much of a headache for investors as corporate bonds are in good demand. However, it's probable that many investors may exit at the same time and no one will buy or provide market-making activities. Then liquidity would evaporate quickly, leaving investors high and dry. The asset management industry is particularly exposed to a sudden drop in corporate bond market liquidity. Investors' expectations of their ability to redeem mutual fund shares or sell ETFs (exchange traded funds) on a daily basis could reveal the low liquidity of the underlying bonds bundled into these funds. In case of a pronounced outflow from funds, many asset managers could be forced to sell into dry markets and incur significant losses.
Chasing the White Rabbit?
In June 2014 Bank of England published "Financial Stability Report" examining the liquidity premium inherent in bond prices. The study found that over the years 2007-2008 the liquidity premium significantly increased: in European investment grade issues from approx. 50 basis points to 200 basis points and in European high-yield issues from approx. 100 basis points to almost 1,200 basis points. This suggests that, in times of crisis, investors chase liquidity and quality. According to the report, the liquidity premium is fairly low at the moment. It raises concerns that current market prices influenced by low volatility and low interest rates do not compensate investors enough for the ongoing decline in liquidity and a potential hike in turbulent times.
Implications for Investors
Investors need to recognize the structural change toward lower liquidity as well as the volatile nature of liquidity, especially buyers of higher-yielding corporate bonds.
- Liquidity is more relevant in turbulent market times, plan ahead and assess to what degree to rely on markets.
- Investors able to hold fixed income securities to maturity can shrug off liquidity concerns.
- If holding to maturity is not an option, investors should check if they are rewarded for the risk of not being able to sell at their convenience.
- Supervisory institutions are increasingly aware of the changes in bond markets. A policy to cushion abrupt movements is not unlikely.
- New forms of trading are evolving quickly. Electronic platforms relying on peer-to-peer trading instead of dealers are expected to grow.
- Standardization of the corporate bond market would simplify trading and market making. Such move would enable electronic trading to flourish.
In the meantime, a closer look at how much an investor relies on liquidity when a security is purchased will help to avoid most of the concerns.