Bond Market Rises to Liquidity Challenge

It absorbed a shock just fine, but trading was in the most-active securities.

In some ways, the $40.7 trillion U.S. bond market just passed an important test: It demonstrated that it could account for rapidly shifting views without breaking down.

This is significant because the Federal Reserve, big banks and investors have spent hundreds of hours studying the health of markets that help determine borrowing costs for consumers, companies and governments. The big fear has been that the infrastructure underlying these debt transactions has been hobbled by new regulations and a lack of modernization, resulting in an inability for investors to act on quick changes in sentiment.

But traders seemed to do just fine this month despite a significant disruption in the status quo. After Donald Trump was elected as the next U.S. president on Nov. 8, traders ratcheted up their expectations of inflation and benchmark borrowing costs. Treasuries and government agency-backed bonds experienced their biggest monthly decline since 2004. Corporate bonds suffered their biggest losses since 2013. Investors suddenly priced in significantly higher inflation and interest rates.

The drop in prices didn't result from thin, inconclusive activity. On the contrary, trading in Treasuries surged to the highest levels in more than five years.

Sudden Surge

Treasury trading volumes climbed to the highest levels in more than five years after the U.S. election

Source: Federal Reserve Bank of New York

Activity in investment-grade and high-yield corporate bonds also swelled, making this month the most active November on record.

Tons of Trade

There's been a record amount of activity in U.S. corporate bonds for a November

Source: Finra

2016 data is from Nov. 1-25

And volumes in debt exchange-traded funds rose to the highest levels of the year.

ETF Explosion

Trading volumes in fixed-income ETFs surged to the highest levels of the year after the U.S. election

Source: BlackRock

All this seems to suggest that these markets operated just fine and should be able to accommodate additional shocks going forward. But there are some small signs of caution.

First, trading was largely concentrated in the most-active bonds, leaving many others out in the cold.

Side by Side

While junk-debt trading surged after the election, it's been concentrated in the most-active bonds

Source: Finra

Investors also turned to stocks and Treasuries rather than trying to significantly alter their less-traded holdings.

Second, the sell-off didn't stem from forced fund liquidations or a huge unexpected default. It was fueled by expectations about Trump's potential policies, not new facts that demanded immediate action. While many investors believe that this rout is the start of a more prolonged rise in benchmark borrowing costs, others disagree, leading to a healthy two-sided market.

Bond markets performed smoothly in November. It's clear traders have come up with new ways to operate, whether it's using more ETFs, holding more cash or keeping a stash of popular bonds on hand. Investors may have experienced some losses, but they were largely able to execute trades. This is how markets are supposed to work, and it helps allay some fears about antiquated bond-trading mechanics. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE