I’ve gotten a huge number of emails and questions on bond market liquidity in the last few months. This has been a topic that keeps getting a lot of discussion so I figured I’d cover some of the basics here just to get some answers out there for those who are curious. I’ll try to keep this short and sweet so as to adequately cover the important points and inadequately cover the depth of the topic. I hope you find it a little helpful.
What is “liquidity”?
If we’re going to talk about “liquidity” it’s probably best to agree on what it is. Liquidity refers to how “deep” a market is. It’s a bit like a pool versus an ocean. If I jump in the pool I cause a big ripple effect because a pool is not very deep. If, on the other hand, I jump into the ocean I don’t cause much of a ripple effect because the ocean is deep. A market that’s deep is not impacted significantly by small or even necessarily large players. If a market is not deep, however, then a large player can have a significant impact on the price at which that market trades.
When we talk about bond market liquidity it’s important to understand that there are lots of different “pools” out there such as high yield bonds, munis, government bonds, etc. These pools vary in depth and their risk exposure to liquidity events will vary significantly.
Why is Bond Market Liquidity a Concern?
In the wake of the financial crisis new banking regulations (such as the Volcker Rule) and increased costs of capital contributed to a substantial decline in dealer inventories. Dealers are market makers and their ability to manage risk in a cost effective manner has been impeded by these regulations leading to the decline in inventories. So, the concern is that the absence of these big players is contributing to higher levels of bond market volatility and could contribute to financial instability.
There’s a fair amount of evidence backing up these worries. In addition to lower dealer inventories we’ve experienced tighter bid-ask spreads (which, interestingly, is a sign of the absence of dealers operating on a principal basis) as well as sharp declines in turnover. My personal experience as well as the experience of many colleagues I talk to is that the lack of liquidity is obvious in trying to implement larger trades.
There has been a fairly substantial pick-up in other players and new technologies in this area, but it has not offset the decline from the banks. People like Ken Griffin say this isn’t a worry, but I am not certain that he’s right. He’s clearly a biased player as much as the banks are for arguing against these new regulations. Griffin says investors will supply liquidity when needed, but that’s not always true in the case of a crisis. Of course, banks don’t always supply liquidity in a crisis either so the bank argument that they won’t be there to support liquid markets when markets get thin, is, well, a pretty thin argument. But their absence certainly doesn’t help.
It’s also worth noting that QE has probably contributed to these concerns as well. This is due to the fact that the reduction in private sector held government bond supply has been reduced which has shifted demand onto the corporate and muni markets. This increased demand has been met with an equally large increase in supply as corporate bond issuance has roughly doubled since 2008. This is great when times are good, but you get an obvious supply/demand imbalance when things are bad.
What Markets are Most at Risk?
Like any potential liquidity crisis the market becomes all about supply and demand at the time of crisis. There is probably a liquidity concern at present, but I don’t know how much the concerns expressed by many banks will matter when push comes to shove. That is because dealers aren’t in the business of holding risk and supporting the price of crashing bonds (unless your dealer name is “Federal Reserve”). And so here’s the kicker. In a crisis style event the current reach for yield will become a reach for safety. And that means investors will rush into the comforting arms of Uncle Sam’s liabilities – US government bonds. And the (upward) price action in these bonds could be exaggerated by the Federal Reserve’s reduction in supply. Likewise, the opposite effect could take place in markets like munis and corporates where supply has boomed and investors have reached for yield.
In short, yes, there’s a liquidity concern. But I am not so certain it’s the changing regulations that we need to be concerned about. Instead, it might just be the unintended consequences of Federal Reserve policy that could pose the biggest difficult if we do encounter a liquidity event.