By Anastasia Amoroso, Global Market Strategist, JP Morgan Asset Management
Living in a less liquid world: What is bond market liquidity and why is it lower today?
If you ask three people in different parts of the capital markets to define bond market liquidity, chances are you will receive three different answers.
Some describe liquidity as the ability to get the trade done no matter the price; others cite the price and the cost of getting the trade done (the bid-ask spread); and still others talk about the depth of the market, which can be observed by looking at the average trade size.
All of these definitions describe a different facet of liquidity. We prefer a definition of our colleague, Nicholas Cox, Global Head of Fixed Income Trading at JP Morgan Asset Management. He put it this way: “Can I get the size I want at the price I can accurately predict?”
The answer to that question today is a solid maybe.
The bid-ask spread, which has moved tighter since the crisis in, for example, US high yield bonds, does not point to any unusual developments. However, the average trade size in the corporate (and Treasury) bond market does. The average trade size in both markets is smaller today than it was pre-crisis.
The depth of the market has diminished, complicating the ability of an investor to promptly execute the trade if the intended size is large. Today’s smaller trade size reflects deleveraging and regulatory change, which means that dealers are not in a position to absorb and hold large blocks of inventory.
Dealers have not only reduced their inventory, but they have also de-risked it (reducing the overall risk level in their holdings). Corporate bonds today represent a small fraction of dealer inventories compared to 2007, as we show in the chart below.
While the supply of dealer bond liquidity and banks’ appetite for corporate bonds have declined, the demand for this liquidity has increased. The share of the corporate bond market controlled today by mutual funds and ETFs has doubled since the financial crisis. These vehicles offer daily or intraday liquidity and are ultimately controlled by retail investors.
That is important because while this category of investors has helped absorb large volumes of new bond issuance, historically retail investors have also been quick to sell. For example, flows into US investment grade and high yield mutual funds have been remarkably strong since 2009, but in the spring and summer of 2013, retail investors rushed to redeem their investment grade bond funds amidst the so-called “taper tantrum.”
If the tide turns again around the date of the first Fed rate hike, the buyers of corporate bonds may become sellers. There would be less scope for dealers to absorb the sell volumes, resulting in faster discounting of prices and extra volatility in the bond market.
We need to balance this with a few observations:
- Lack of liquidity does not trigger episodes of volatility—events do
- Even in a world of lower bond liquidity, the high tide of volatility tends to recede with time
- There are long-term pillars of support in the US corporate bond market, namely insurance companies, pension funds and foreign buyers. Although these investors do not step in overnight to buy bonds (and they can’t alleviate the short-term lack of liquidity), they do step in over time as their investment needs dictate.
Armed with an understanding of liquidity challenges and bond market dynamics, what should investors do?
Do’s and Don’ts for bond investors
As the supply of dealer and bank bond liquidity declines and the demand for it rises, in times of market dislocation bond prices may experience faster discounting and greater uncertainty. However, as rates rise and spreads widen, a large cohort of willing buyers, such as institutional and international investors, could help stabilize the market over time.
- Do consider carefully what event causes spreads to widen. The onset of volatility may be exacerbated by a lack of liquidity, but is initially triggered by an event. Has the event, whenever it occurs, fundamentally shifted the quality or the default risk of a corporate bond? If the answer is yes, then it may be time to sell. If not, selling might not be the best answer.
- Don’t sit on the side lines forgoing valuable coupon income and don’t rush out of your corporate bond fund if the fundamentals have not changed. Volatility is like the tidal cycle, it rises and then it recedes.
- Do diversify your fixed income allocation away from single factor interest rate risk. Find diversified strategies that give you optionality to benefit from potential dislocations and help diversify your interest rate exposure. Don’t bet on one set of rates and credits, and instead do capitalise on many.