A quick look at bond market liquidity

Market Liquidity After the Financial Crisis

This is a good update on market liquidity. Market liquidity is important for many reasons, but one in particular is that the financial crisis was a liquidity crisis; not a debt crisis. More specifically, when liquidity dried up, the banks could not repay the short-term loans they borrowed to lend for long-term purposes (mortgages). To keep this from happening again, it is important to monitor and regulate dealer balance sheets going forward.

The authors take a look at liquidity based on balance sheets. As you can see below, balance sheets have decreased over the last few years.

balance sheets

This indicates that banks are less risky today; which is a positive development.

The authors also look at spreads on Treasuries and corporate bonds and they find that Treasury spreads are stable and corporate spreads vary based on trade size.

corp bid ask spread

I find this trend to be interesting because it indicates that there is more interest in corporate bonds from retail (smaller) investors relative the past. This is indicative of an aging and retiring population who are buying bonds. On the other hand, the bid ask spread for larger investors (institutions) is higher relative to prior to the financial crisis. This would seem to indicate that bond liquidity in the institutional market is weaker; despite significant bond issuance in recent years. I reconcile this by thinking about credit quality in two ways.

First, corporations have levered up over the last few years. So, institutional buyers are concerned about the ability for the issuer to repay the debt upon maturity. And second, credit ratings for a number of companies have declined. As the credit rating declines, the companies bonds are no longer allowed to be bought by certain institutions. For instance, the Barclay’s US Agg Index cannot purchase high yield bonds and buys mainly top rated issues. Thus, if a company’s credit rating drops, the demand for their bonds will decrease the spread will widen.

Now, this does not explain why retail spreads have declined, but my intuition tells me that this has to do with the data set used; which the authors mentioned is not perfect.

Categories: Bonds, Finance, Liquidity

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