Along with a decline in liquidity, issuers of securities also noted the greater degree of difficulty they had in gauging the market and pricing new issues of benchmark bonds. They also noted the trend of investors demanding larger, more liquid benchmark bonds.
The BIS released their quarterly review at the beginning of December. In the lead article, the authors noted the resilience of the major capital markets as they digested the surprising news of Brexit and the Trump election. In the case of the US election, initial moves in some markets amounted to approximately five standard deviations of daily price changes. In the case of the US 10 year, the abrupt 20 bp increase was greater than all but 1% of one-day movements in this yield over the last 25 years. The authors declared that “market functioning proved resilient despite large price moves overnight and over the following days. Market liquidity remained adequate.”
In the Bank of Canada’s most recent Financial Stability Report, they too came to the same conclusion saying “that there was no widespread, long lasting disruption in fixed-income markets” and that liquidity remained resilient.
I will leave it to those that were trading during the events to determine whether their assessments are correct. I think anyone involved in fixed income markets would suggest that liquidity in these markets has deteriorated since the 2008 crisis.
Liquidity is important to markets. In order to properly protect capital, it is vital to be able to adjust asset portfolios in a timely and cost-effective manner when the economic or political environment changes. The intent of the regulatory changes phased in post 2008 was to reduce a perceived over-abundance of liquidity that existed prior to the crisis in the financial system. In the eyes of the regulators, if it is too easy to transact in a security, not enough attention is spent by the holder in understanding the inherent risks in the product. Why understand the complexity of an asset backed bond when you believe you can easily sell it before it goes bad. Thus the new rules have made it more costly for intermediaries to trade and to temporarily hold inventory of riskier assets on their balance sheet in order to temper market liquidity. The regulators are now asking themselves whether they got the amount of reduction right.
The Canadian Fixed Income Forum recently released their survey results on liquidity that gives us a look at the changing domestic landscape. The focus of the exercise was to determine the degree of deterioration in fixed-income market liquidity that has occurred over the last two years in fifteen categories. (This, of course, misses the degree of deterioration that occurred from 2009 to 2014, as they seem to be assuming market participants do not change their behaviour until the rule changes have been enacted.) They received responses from over 200 firms globally and have posted their analysis on the Bank’s website.
Not surprisingly, the survey showed that respondents want to work in an environment where they can do their job. They want a consistent level of daily liquidity in order to transact, one where they can deal in reasonable sizes without moving market prices. More importantly, the respondents want to have liquidity available to them during times of market stress, like a Brexit or Trump win.
In normal times, it looks like the regulators have the level of liquidity about right with regards to government product, but not right with corporates. Given the regulatory incentives, this should not be surprising. The results show that there has been a greater deterioration in the ability to transact riskier assets. While liquidity of government issued benchmark bonds have held in well, products such as non-financial corporate bonds have seen their liquidity decline notably. In the ranking of markets by liquidity, this latter category ranks 14th out of 15 with only repos of non-government product being less liquid.
The extent of deterioration in corporate bond liquidity is revealed by 70% of respondents noting that they have been unsuccessful in executing an investment grade corporate bond transaction within a reasonable period of time over the last 2 years. As a result, 75% of survey participants have had to change their corporate bond execution strategy, the biggest trend being greater reliance on agency trading than 2 years ago. (This is where the intermediary on behalf of their client attempts to find a buyer or seller for a security instead of having to transact and have the security put on its balance sheet). The decline in liquidity has also lead to transacting less, needing more time to execute and demanding a higher premium to compensate for the lack of liquidity of the underlying bond. And this is in normal times.
While investors struggle, the issuers of securities noted the greater degree of difficulty they had in gauging the market and pricing new issues of benchmark bonds. They also noted the trend of investors demanding larger, more liquid benchmark bonds. Great if you are a larger, consistent issuer of bonds but more challenging for smaller, less frequent borrowers.
When asked how to improve the underlying liquidity, the suggested solutions centred on creating larger benchmarks, having better pre-and post-transparency and having access to more trading platforms. In fact, 45% believe that being allowed to trade on a all-to-all platform, where both intermediaries and investors have access to transact, would help. While these steps may marginally increase liquidity, as long as regulation makes it more costly for intermediaries to temporarily hold riskier assets on their balance sheets, the regulators have eliminated a number of sizeable temporary buyers for this type of product in normal times, let alone in a time of crisis.
The Bank in their Financial System Review said, “the regulatory reforms are designed to make the financial system safer, in part by reducing the risk that dealers take on their balance sheets.” I would argue it may have made the banks and the dealers safer, but at the expense of the market, specifically the end investor. It must be very difficult for someone involved in the corporate bond market to feel that the financial system they deal in is safer or that the market is resilient and that liquidity is adequate.
Holders of corporate bonds, non-financials in particular, need to understand the degree of illiquidity that this asset class now has. With the risk-free rate moving off the floor in the US, one should keep in mind that the exit door at the back of the theatre is very narrow in case of fire.