Significant focus has been given to fixed income market liquidity over the last several years as new regulations have ushered in sweeping changes to how most fixed income markets are intermediated. The full extent of these systemic changes has not yet been fully understood by most—and is nearly impossible to completely quantify—which is one of the reasons for recent consternation about the new liquidity environment for fixed income.
To start this conversation, it’s important to define what market liquidity is. For this, we turn to former New York Federal Reserve President and former U.S. Treasury Secretary, Tim Geithner. In 2007 he defined liquidity as “the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices.”1
Well said, Mr. Secretary—and now we can begin our discussion, perhaps by challenging some common myths about the fixed income market.
Myth #1: Trading volumes in the corporate bond market have declined since the financial crisis of 2008.
This notion is an easy one to dispel. Exhibit 1 shows the three-month average of daily trading volume. Since 2006, trading volume in the investment-grade corporate bond market has doubled. Volumes in the high-yield market have risen meaningfully as well but have not quite doubled.
But now you might ask: Hasn’t the corporate bond market grown substantially since then?
The answer is yes: The market has grown as well, with corporate issuers taking advantage of low interest rates and tight credit spreads—and moving away from some other forms of financing, such as bank loans. However, even if we take trading volume as a share of market size, we can still see that the turnover ratio (i.e., the extent of trading in the secondary market relative to the amount of bonds outstanding, which is one critical measure of market liquidity) of investment grade bonds has rebounded over the last two years to pre-crisis levels. The turnover ratio of high-yield bonds remains depressed compared to pre-crisis levels but has remained steady for the last five years—and has not deteriorated. In Exhibit 2, we show these turnover ratios, which are market volume as a share of the relevant benchmark indices.
In other words, it’s true that trading volumes have risen with market growth, but liquidity—at least in terms of turnover ratio—has bounced back for investment-grade bonds and leveled off for high-yield bonds. And the myth of collapsing trading volumes in the corporate bond market is busted.
Myth #2: Dealer appetite for fixed income assets has fallen
This second myth is actually a fact (Exhibit 3)—but its implication is not what you may think.
Exhibit 3 makes clear that dealers indeed have less appetite for holding fixed income assets and for maintaining bond risk. Fixed income trading assets have fallen by 40% since mid-2009 and highlight how new rules, particularly Basel capital requirements, are affecting banking and broker/dealer activities. These new rules require significant equity holdings against many fixed income assets, of which the most challenging to hold are corporate debt and structured credit products, such as non-agency mortgages.
However, when it comes to fixed income, the volume of assets held by a dealer is not the best proxy for assessing how much risk is being taken. It could well be that dealer books hold less notional value (i.e., the total amount of a security’s underlying asset at its spot price) but are taking more credit risk or interest rate risk. Yet the value at risk (VaR) of banks’ trading assets has fallen even further. Among the large global banks2, trading assets have declined substantially, while the VaR of these assets has fallen by 70% since the financial crisis of 2008. This trend suggests a shift from corporate bonds and structured credit products into traditionally less risky assets (such as Treasuries and agency mortgages) and generally to shorter maturity bonds, which typically have less interest rate risk.
Additionally, dealers’ risk appetite may be lower (which suggests that on-demand liquidity might be reduced), but it’s the appetite of “end users” (i.e., the buyers of corporate bonds) that really matters, because they are the ones that collectively set bond prices. Demand for corporate bonds by pensions, mutual funds and non-U.S. investors continue to grow. Demand for U.S. fixed income abroad has become particularly robust given the low interest rates in Europe and Japan. Exhibit 4 shows how these four investor groups own nearly $8 trillion in U.S. corporate bonds collectively.
So, “myth #2” is not a myth. Dealers’ diminished appetite for bonds suggests that liquidity might be more challenged, yet there continues to be strong demand for bonds among large buyers. This suggests volatility might be greater and bid/offer spreads might be wider, but the actual ability to sell bonds should continue to exist.
Myth #3: Bid/offer spreads of corporate bonds have continued to widen since the 2008 financial crisis
This myth is plausible, as we can’t confirm it.
Since the 2008 financial crisis, more data has been collected on fixed income markets, including bid/offer spreads of corporate bonds. We can use this data to see if these spreads have been steadily wider or trending higher since the crisis. Exhibit 5 shows how investment-grade bid/offer spreads have remained relatively stable since 2012, with larger trades receiving better treatment than smaller “odd-lot” trades. (Generally, bid/offer spreads for round lots and block trades have declined since the financial crisis.) But there has been no real discernable trend of widening spreads.
Anecdotally, we know that before the crisis, spreads tended to be 5-10 basis points for typical trades. This range appears to be the norm today and suggests that liquidity has returned to pre-crisis levels, though not across the board.
Over the last several years, sectors experiencing financial trouble have had more liquidity issues than others. Additionally, sectors in which credit spreads are volatile tend to have very wide bid/offer spreads. Examples include the telecom sector in its tumultuous period of the early 2000s; and banks during the 2008 financial crisis and again during the European/Greek debt crisis (Exhibit 6 for the latter). During the last two crises, bid/offer spreads on bonds of banks and other financial institutions were above 10 basis points, while other sectors saw only a modest widening of spreads. More recently, the energy sector saw credit spreads widen substantially more than most other sectors experiencing volatile credit spreads.
Our call on myth 3 is that it is plausible. Given the lack of balance-sheet information, dealers are unlikely to support distressed sectors. This phenomenon is not new, but it suggests that markets may move dramatically should there be significant selling of corporate bonds.
Some myths about liquidity in the corporate bond are indeed myths, while others are actually facts or simply unverifiable. Either way, there are market risks that, in our view, warrant maintaining a diversified set of fixed income assets—both across corporate sectors and more broadly across the fixed income markets.
In closing, we believe that actively managed exposure to corporate bonds and fixed income can help investors avoid sectors at the onset of distress while taking advantage of subsequent recoveries to potentially outperform passive fixed income strategies.
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1 Tim Geithner, 8th Annual Risk Convention and Exhibition, Global Association of Risk Professionals, New York City, February 28, 2007.
2 Source: Credit Suisse, 3/31/16. Banks analyzed include Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, JPMorgan, Credit Suisse, Deutsche Bank, UBS, Barclays, BNP Paribas and Societe Generale.
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The Barclays U.S. Aggregate Index is an index of U.S.-dollar-denominated, investment-grade U.S. corporate government and mortgage-backed securities.
The Barclays High Yield Index is often used to represent dollar-denominated high-yield bonds trading in the United States.
The indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk.
These views represent the opinions of the portfolio managers of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.