Liquidity is like good health. You don’t really appreciate it until you lose it.
Investors are starting to appreciate it. As volatility has surged, first in the stock market and now in credit markets, liquidity is starting to dry up across segments of the corporate bond markets. The ominous widening of spreads in the high-yield bond market — from 322 basis points on Oct. 2 to 422 points on Nov. 20 — could be a sign of trouble to come.
For bond investors liquidity is the ability to sell a bond at a reasonable price (close to where it last traded) in a reasonable amount of time. For most of the last 10 years — with a few notable exceptions — fixed-income investors have not had to worry about liquidity.
For one thing, the Federal Reserve and other central banks around the world were flooding markets with cash and pushing investors into higher-yielding assets, such as stocks and corporate bonds. There have been isolated instances of market turmoil, such as the Taper Tantrum in 2013 and the blowout in high-yield energy bonds when the price of oil tanked in 2015–16, but for the most part, fixed-income markets in the U.S. have been orderly since the financial crisis.
“We haven’t seen a lot of indicators yet of less liquidity in fixed-income markets,” said George Rusnak, co-head of global fixed-income strategy at Wells Fargo.
“The credit markets have been relatively calm,” said Matt Toms, chief investment officer for fixed income at Voya Investment Management. “There’s been some widening of spreads in the high-yield and investment-grade markets recently, but it hasn’t caused any forced selling by investors.”
Not yet, at least. The long period of muted volatility in the bond markets, however, may be coming to an end. The central banks — the Fed, most prominently — are now tightening monetary policies, and spreads are widening across corporate bond markets. A severe liquidity crisis like 2008, when whole swaths of the credit markets shut down, may be unlikely, but there is concern that the post-financial crisis bond market could be vulnerable in a period of sustained volatility.
The big change in the bond markets since the financial crisis is the diminished role of the banks and investment dealers as investors and market makers. Prior to the crisis, banks and brokers kept large inventories of corporate bonds and issued quotes to buy and sell them with customers in the market.
For better and for worse, the regulatory reforms adopted post-crisis changed the system dramatically. Stricter capital reserve requirements by the Fed and rules against proprietary trading by regulated banks (aka, the Volcker rule) both reduced the willingness of banks and bond dealers to finance inventories and changed their role in the marketplace from principal to agent.
“The banks are in a better state now, and there’s less systemic risk in the financial system,” said Martin Fridson, a former Wall Streeter who now writes about the bond markets. “The unintended consequence, however, is a reduction of liquidity in corporate bond markets.