Is the spectre of illiquidity again stalking global bond markets?
There has been much debate recently about the state of liquidity, or lack of it, in global bond markets. There have clearly been big changes in who is providing liquidity since the crash of 2008–09. While some markets seem unaffected, we highlight others where alarm bells are starting to sound.
Historically more attention has been paid to default risk than liquidity risk in the credit market. But the changing nature of both the market and its investors over the last five years has switched attention towards the latter. Regulatory limitations on banks’ proprietary trading activities – prompted by the “Volcker rule” – are said to have reduced the depth of market-makers’ inventories at a time when ETFs and other index funds have steadily increased their market share. The worry is that this could create a liquidity squeeze at a moment of market panic.
In this article, we look at some of the ways of measuring liquidity and find cause for concern in some parts of the market. We conclude that investors need to tread carefully, particularly when using passive funds, which may unexpectedly expose them to active risk at times of market stress. Retaining the ability to pick and choose amongst different securities can be an important way of mitigating that threat and providing a smoother performance.
Market participants measure the state of liquidity in many ways. One is simply to look at the difference between the prices at which investors buy and sell, the bid-ask spread. This is typically wider for less liquid and infrequently-traded bonds, and tends to widen
further as the transaction size grows (left-hand chart in Figure 1). When liquidity is low, both the bid-ask spread and the degree of price movement for larger-size trades worsen.
A complementary measure analyses this “dispersion” for the overall market, measured as the difference in spreads between similar securities. When there is more liquidity in the market, issues tend to exhibit tighter dispersion than when liquidity is in short supply (right-hand chart in Figure 1). Wider dispersion can be due to the absence of arbitrageurs in the market and/or dealers not carrying sufficient inventories in specific bonds.
Using a variant of this second measure, we can analyse the market in US Treasury bonds, one of the most readily tradable assets in the world. The most traded Treasury security is usually the most recently issued, known as the “on-the-run” bond. Because it is the most liquid, it tends to attract a higher demand, which in turn pushes its price up and lowers the yield compared with other similar bonds. We can therefore test the liquidity of the market by looking at the yield differential between the on-the-run bond and the second most recently issued bond, called the first “off-the-run” bond. As Figure 2 shows, the premium for liquidity in on-the-run bonds was extreme during 2008 and rose again somewhat more gently in 2010-2013, but has been falling in the past two years. It is now virtually nonexistent, possibly as a consequence of the expansionary monetary regime seen of late.