Regulatory changes and market conditions have decreased liquidity in the secondary bond market, even as new issues remain strong. While market players generally agree that liquidity is important for the fixed-income market, thoughts on just how much liquidity they feel is needed – and how to achieve an increase – will vary on the type of market player you ask.
The Financial Pipeline spoke with three fixed income experts to get their take on the state of liquidity in the bond market and what could be done to improve it. Here are their edited responses.
Barbara Hooper, EVP, Treasury and Balance Sheet Management, TD Bank Group.
If you think about the corporate bond market specifically, over the last number of years the market has actually become less liquid, for a couple of different reasons.
One is because of some regulatory changes, which really weren’t designed to take liquidity out of the market but made it more expensive for bond dealers to hold inventory of bonds on their balance sheet and they did limit in some ways certain types of trading.
The other reason that liquidity has come out of the market, especially the U.S. market, is that some of the banks that have been a little bit more challenged have had to exit the market. The European banks in particular used to be quite active in the U.S. bond market and have had to pull back quite materially. That reduction in the liquidity doesn’t affect TD Bank that much, because we’re a very large issuer with a good credit rating and a big investor following, but for smaller issuers the impact has been more pronounced.
When spreads tighten, initially liquidity comes out of the market, but then the dealers adapt and they refine their business model to be a lower cost business model and liquidity restores to some extent. We’re starting to see that. We’re also starting to see … new players coming into the market … because the withdrawal of European banks created room for that.
I personally wouldn’t advocate for a lot of change in regulation. I think much of the regulation that has come into place, even though it has had this somewhat unintended consequence, had a lot of other positive results.
Brian Carney, Vice-President, Canso Investment Counsel Ltd.
In Canada, on average, $2.4 billion corporate bonds trade daily. That said bond market liquidity is not uniform. Shorter dated, higher-rated, larger issues trade more frequently (i.e. are more liquid) than longer dated, lower-rated, smaller issues. The reality is liquidity in the credit markets is fleeting – too much is available when less is required and too little when at least some would be useful.
The question asked implies the current corporate bond market is not liquid enough and therefore an increase in liquidity is a desirable outcome. We don’t see the economic or financial market benefit in having people flip bonds frequently versus holding them longer term. Investment dealers who generate profits based on transactions are the direct beneficiaries of increased liquidity.
The practical yet unpalatable truth is that when everybody is buying, nobody wants to sell since prices are going up and when everyone is selling, nobody wants to buy since prices are falling. As a value-oriented corporate bond investor, the most important contributor to our long-term performance is our ability to buy cheap stuff. We prefer markets where there are few buyers, many sellers and wide bid ask spreads. For us value comes in less liquid, not more liquid markets. We sell into strong markets, when securities we own are well bid and their valuations are expensive.
When we buy a security we expect to hold that security to maturity. Transient holders of corporates, including investment dealers, muddle the valuation of securities and distort markets by acting as principal. We would argue that the market should aspire not to increased liquidity as measured by transaction volume, but to a market where investment dealers act as agents transferring risk amongst investors pricing risk they are willing to assume for the duration of a security.
Laurence Booth, a professor of finance with The University of Toronto’s Rotman School of Management.
There is liquidity in the benchmark bonds (but) the corporate bond market is not very liquid, most of it is just purchased by insurance companies and pension funds and held for long periods of time.
In Canada, it’s essentially a dealer market – you have to go through the Canadian dealers.
There have been repeated attempts to increase liquidity in the bond market, and there are always some bond issues that are available, but to create liquidity you’ve got to get people willing to buy and sell.
In the bond market, somebody (also) has to hold inventory. And anything that increases the cost of holding inventory (will lead to) a reduction in liquidity.
After the financial crisis, the U.S. government imposed regulations that basically restricted the U.S. investment banks from holding bonds, which means there has been a deterioration of liquidity in the bond markets.
One way (to increase liquidity) would be to loosen regulations on the banks, (but) I don’t think that’s going to happen.