When liquidity is most needed in the high-grade corporate bond market, it “could get ugly,” Bank of America Merrill Lynch predicts. While total volume has increased meaningfully since 2006, don’t let that fool you. The markets are not liquid, the analysts say, pointing to the Volcker Rule and central bank quantitative easing that has put investors reaching for yield on a ledge.
High-Grade Corporate Bond Market Market - Don't conflate volume with liquidity
High-grade corporate bond trading has nearly doubled in the decade following the global financial crisis, BofA’s Hans Mikkelsen and Yunyi Zhang observe. With annual volume at $4.1 trillion, don’t make the mistake of conflating volume with liquidity.
In a report titled “When the tide goes out,” Mikkelsen and Zhang consider trading volume as a share of market size and point to a declining picture.
Annual trading volumes in the high-grade corporate bond market were 135% of the size of the market back in 2006, but post-crisis they estimate that number is only 86% in 2017.
There are numerous methods to gauge market liquidity, with bid-ask spreads being one. The message this measure is sending is not as positive as market volume numbers might lead observers to believe.
“Counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels,” the report observed, pointing to bid/ask spreads even though they “are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds.”
High-grade corporate bond market data on bid ask spreads is not often tracked and when it is only in markets with strong liquidity and trade volume. “In contrast, liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders,” they observed. In fact, what Mikkelsen and Zhang think might play out a "back to the future" effect.
"This could get ugly" -- Liquidity in high-grade corporate debt "back to pre-crisis levels"
The high-grade corporate bond market measures BofA tracks are now “back to pre-crisis levels.”
What is causation? Quantitative stimulus, which is set to ever so gently begin to end this September when the US Federal Reserve will pull back bond buying with just the interest dividend it receives (but keep intact the vast majority of the program.)
Quantitative easing and artificial stimulus combined with restrictive regulation that has led markets to this odd place in history, BofA observes.
“In the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market,” BofA observes. “Because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds,” bond buyers have been forced to reach to illiquid off-the run issues and odd maturities. This “naturally compresses the off-the-run/on-the-run liquidity measures,” which could have a meaningful impact.
If there is one benchmark for textbook bending quantitative easing it is how tranquil the market environment appears. But just like a sudden squall that can sink boaters, the dead calm can be broken with startling speed. “This means everything is OK until it is not,” they noted, looking for the point when interest rates rocket higher and large outflows rue the day. “Will we see just how illiquid the corporate bond market can be in the new regulatory regime.”
If the crash they are predicting occurs, BofA has its sites locked on causation as well as a model for how it will unwind. They think initially liquid names and maturities will underperform as a flood of selling demand hits markets, but doesn’t capsize the boat.
But once liquidity begins to dry up, the real problems begin.
“When investors find they can no longer sell the vast majority of bonds they own – the off-the-runs – at meaningful prices we get a big widening in liquidity measures," the report noted. "This could get ugly, we think.”
BofA is part of a list of bank analysts who have been making predictions regarding a bond market crash. None of them have occurred... yet.