There has probably been no subject more discussed at fixed income conferences or by the media for the past several years than the perceived lack of liquidity in the global corporate bond markets, says George Bollenbacher, a 20-year bond industry veteran, now head of fixed-income research at Tabb Group.
In a new market research note – The Search for Corporate Bond Liquidity: Derivatives to the Rescue? – he says a 2016 rule promulgated by the SEC, Investment Company Liquidity Risk Management Programs, has added urgency to the definition of and the search for liquidity in the corporate bond markets. But there are three key questions that Bollenbacher says need to be addressed:
· What is liquidity?
· How do we measure it?
· What’s the status of corporate bond liquidity today?
Citing four references – a 2011 paper by Gabrielson, Marzo and Zagaglia entitled, “Measuring market liquidity: An introductory survey”; a 2011 IMF paper entitled, “Measuring Liquidity in Financial Markets”; a 2003 New York Fed paper, “Measuring Treasury Market Liquidity”; and the Federal Reserve Board’s web page listing Corporate Bond Liquidity Reports – he shares his definition “as the ability to do transactions in a particular instrument in typically average size, quickly and without undue price concessions.”
One problem with all the definitions of liquidity is that they don’t lend themselves easily to measurement, but in the end, market participants seem to agree that liquidity across a bond’s life cycle is lower than it was before the financial crisis, and that issue is especially pronounced the older the issue is. “This phenomenon,” he says, “could be accentuated by the tendency of retail investors, often the holders of ETF positions, to be pro-cyclical in their behavior.
According to Bollenbacher, one area of increased interest, both by liquidity makers as well as liquidity takers, is derivatives, two types in particular: bond index futures and bond index total return swaps (TRSs). However, he explains, the use of derivatives as liquidity sources in the corporate bond market is dependent on two couple of critical developments:
- For the TRS, the first critical ingredient is the clearing of the instruments. Not only does this requirement standardize the product, which is a necessary precondition to enough trading volume to jump-start liquidity, it makes the product easily compressible, which is a prerequisite for its use as a short-term hedge.
- For both derivative types, the second ingredient is the need for a sufficient number of market-makers to generate the necessary liquidity. Like all other markets, the growth of liquidity is very much a chicken-egg phenomenon. In order for liquidity takers to begin using the product, liquidity makers must be there to trade. In order for liquidity makers to step up to the plate, there must be sufficient demand by the takers to make it worthwhile.
That may make it sound like starting these products is “Mission Impossible” but according to Bollenbacher, we all know of markets for various instruments that started from nothing and became a sine qua non, always requiring risk on the part of those who introduce the products,, not to overlook good timing as well. “Given the current projections about interest rates, and the increasing leverage of corporations worldwide, it certainly looks like the timing is right. Will the products adapt and will the users embrace them? I think we all hope so.”
The 8-page market note is available for immediate download by TABB Group fixed income clients and pre-qualified media at https://research.tabbgroup.com/area/fixed-income.