The FCA says that liquidity in the corporate bond market has actually improved in recent years, rather than being lower, as many market participants believe.
A study carried out for the regulator on liquidity in the corporate bond market from 2008-14 states that there is “no evidence that liquidity outcomes have deteriorated in the market”.
The study and subsequent Occasional Paper, which does not necessarily reflect the FCA’s views, state that there is “little evidence” that liquidity is having a larger effect on bond spreads now than a few years ago.
“We do not find evidence that liquidity has become more ‘flighty’ in response to shocks of a mild to moderate nature, as measures of liquidity risk do not increase over the period of analysis,” states the FCA.
Previously market participants had warned that bond market liquidity had deteriorated, with Man GLG’s Jon Mawby warning that the liquidity crisis could be larger than the money market failure in 2008.
The FCA acknowledges that liquidity is affected when the market is under “severe stress”. It gave the example of 2009-10 when there was “considerably less liquidity” than before or after that period.
Other examples of liquidity becoming more “flighty” include the 2013 taper-tantrum and the US treasury flash-crash at the end of 2014.
The FCA found that primary dealer inventories had dropped between 2008 and 2014, from around £400bn of inventories in mid-2008 to £250bn at the end of 2014.
“However, such decline in inventories did not imply a reduction in liquidity in the market,” the paper states.
“All the measures of illiquidity show a remarkably consistent pattern: they start from reasonably low levels at the beginning of our sample (2008 Q1), then increase for the subsequent quarters when the financial crisis hit, and subsequently decline to a very low level by the end of 2011, remaining stable ever since.”
“For investment grade bonds, the composite liquidity measure is responsible for, on average, 0.01 basis points of the credit yield spread – not statistically different from zero. For speculative bonds, the contribution of the liquidity measure is 13.5 basis points, or 3.4 per cent of the total spread,” the paper states.
“Our results should not be misinterpreted to imply that there are no risks associated with liquidity. Our claim is weaker: there is not less liquidity in normal times and liquidity has not become more ‘flighty’ when shocks of a mild nature hit the system,” it adds.
In the study the FCA looked at transaction level data, stating it was the first systematic assessment of liquidity in the UK corporate bond market.
In 2014 the FCA warned about corporate bond market liquidity, telling investors that they may find it hard to access money in corporate bond funds quickly during difficult market conditions.
At the time the regulator warned about low trading activity in the bond markets and that the market for underlying bonds had shrunk in recent years.
Investor concerns over liquidity in the world’s corporate bond markets have been well documented in recent times. But just how much weight should be applied to headlines warning of a ‘life without liquidity’?
FCA economists Matteo Aquilina and Felix Suntheim.
That bond markets pose specific liquidity challenges for investors is certainly not in any serious dispute. Even in the best of times, bond issues can be thin. Locating a willing buyer for the exact bond you’re selling is not always easy in a market with an array of different interest rates, maturities and multiple bonds for every issuer.
However, in the absence of any decisively accurate measures of liquidity, those fears have never been easy to objectively quantify. Commentators have instead tended to rely on useful, but limited proxy measures for answers.
For the most part, this lack of clarity seems to have swelled pessimism in the post-crisis world. Regulation, or so the argument goes, has played its own part in that story, for instance, by raising the capital costs associated with holding bonds. Banks are therefore holding on to less of them, driving less activity in the market and, ultimately, less liquidity.
Putting to one side any arguments over whether pre-crisis liquidity was artificially high due to the implicit subsidy of ‘too big to fail’, it is true inventories have fallen significantly. FCA regulatory returns suggest UK dealers held around £400bn of corporate bonds on their trading books in mid-2008, but just £250bn at the end of 2014.
However, transaction data released today by the FCA implies no corresponding drop in liquidity in the UK’s £2.5tn corporate bond markets. In fact, aside from a relatively brief period immediately after the crisis, illiquidity has been decreasing to very low levels. In numerical terms, roundtrip costs – a reliable indicator of liquidity – had declined from a peak of around 0.5pc in 2009, to 0.1 per cent at the end of 2014.