In re Bond Market Liquidity

by Pat Luby

A recent Wall Street Journal article (“A New Mystery Bedevils Fed Data,” WSJ November 10, 2015, by Katy Burne; link provided for subscribers) draws attention to recent data provided by the New York Fed,

Large U.S. banks reported negative corporate-bond inventories for the first time ever by one measure, the latest twist in a market being remade by rising investor demand and declining stockpiles at dealers that buy and sell the debt.

The figures are being closely scrutinized on Wall Street amid concerns that liquidity, reflecting the capacity to buy or sell quickly without moving market prices, has been in decline and could become more challenging as the Federal Reserve prepares for its first interest rate increase since 2006.

Any bond market participant would likely agree that this reflects the current reality of reduced liquidity.

The New York Fed data has been used as a proxy for dealers’ wherewithal to facilitate client bond trades.

“The regulatory environment has caused dealers to change how they trade and position corporate bonds,” said Andrew Brenner, head of international fixed income for broker dealer National Alliance Capital Markets.

Yes–liquidity in the cash bond markets is much different and much less than it has been in the past, and that has been driven (or accelerated) by the regulatory changes. The regulatory changes affecting dealers, however, do not have a direct impact on demand–some of which has shifted from direct ownership in bonds to exposure through ETFs. Because many investors are now accessing the bond markets by using ETFs, when there is a need to adjust a portfolio, if the adjustment is done by using ETFs, the portfolio shift may no longer create trading flows through the books of over the counter bond dealers.

As a result, the liquidity experienced by an investor who has exposure through bonds and ETFs may not be as constrained as would appear from the Fed data about the bond dealers.

Keep in mind that liquidity in fixed income ETFs arises from demand for the underlying bonds as well as from a broad variety of ETF market participants: the Authorized Participants, equity market traders, speculators and hedgers, as well as other investors using the ETFs as a tool to access the bond market.

At the macro level, this question really needs deeper analysis, looking at a combination of over the counter flows and ETF trading flows, as well as creation / redemption activity.

At the micro level, investors need to be thinking in advance about their future liquidity needs and plan their portfolio implementation in advance–before they add positions. 

For additional comments on liquidity and portfolio implementation, see my earlier article Bonds are not Stocks.

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