Everyone's Been Worried About Liquidity in the Wrong Bond Market

Trouble is lurking in the biggest market there is

Who turned off the taps?

Bond market liquidity is terrible, goes the familiar refrain across Wall Street.


While liquidity is a notoriously difficult concept to define, a simple interpretation is investors' ability to buy and sell a security without significantly impacting its price. For years now, the $7.5 trillion U.S. corporate bond market has been the center of liquidity concerns as investors, traders and regulators all fret about the ability of investors to exit their large positions in such securities. With interest rates hovering around zero, U.S. companies have rushed to issue debt and investors have been all too eager to snap it up. At the same time, post-financial crisis regulation has made it more expensive and more difficult for big dealer-banks to hold such bonds on their balance sheets and facilitate trades for investors. 

A duo of research notes published late last month suggest that the focus on investors' ability to trade corporate bonds is misplaced. For all the talk of slumping liquidity in the corporate bond market, it's the boring old U.S. Treasury market where the trend has been most pronounced.

Nikolaos Panigirtzoglou and his team at JPMorgan, for instance, find that; "The past three years have seen a divergence with an improvement in the market depth for US corporate bonds but deterioration in the market depth for government bonds." They pin the decline on new regulation that makes it more difficult for banks to lend out Treasury securities in the vast and shadowy repo market, as well as the Federal Reserve's quantitative easing program which has essentially seen the central bank take big chunks of the market out of circulation.

Bond market liquidity charts - JPMorgan

Over at Deutsche Bank, strategists Oleg Melentyev and Daniel Sorid mount a similar argument. While the corporate bond market has exploded in size and the debt sold by junk-rated, or high-yield (HY), companies is often considered to be the most difficult to buy and sell, the actual trend of declining liquidity is most pronounced in the $12.5 trillion U.S. Treasury market, they say. 

You can see the dynamic in the below charts, which show trading volume of junk-rated corporate bonds, investment-grade (IG) corporate bonds and U.S. Treasuries against their respective market size. Junk bonds traded 0.7 percent of their market size on an average day in the past year while investment-grade traded 0.4 percent and Treasuries traded 4 percent.

But while U.S. Treasuries enjoy the highest amount of absolute liquidity by this measure, the market's relative drop in liquidity in recent years has eclipsed that of junk and investment-grade corporate debt. According to the Deutsche strategists, U.S. Treasuries have lost 70 per cent of their trading depth since the financial crisis, while high-yield and investment grade bonds have lost 30 percent and 50 percent respectively.



These findings have significant implications as to how investors should be positioning themselves to take advantage of liquidity vacuum points that undoubtedly await us in the future. Instead of watching HY market for the signs of cracks, they should be spending more time monitoring higher quality portions of the market going all the way up to Treasuries. The experience of last year’s October 15 is very important in this respect in that it serves as a preview of what a liquidity vacuum experience is likely to feel like. The 10-year Treasury yield experienced a seven-sigma intraday move during that session, triggered by temporarily thin volume at some point, and exacerbated by dealers pulling a plug on their electronic trading systems on early signs of volatility.

In layman's terms, a seven sigma is a once per 1.6 billion year event. These types of things shouldn't really be happening at all, although they inevitably do (the takeaway here is clear: we shouldn't really be using normal distributions to attempt to predict market events). 

In any case, the notion of declining liquidity in the U.S. Treasury market is a big deal since it seems to be happening just as the Federal Reserve is preparing to raise interest rates. 

Here are the Deutsche Bank strategists on the rather big implications:

The key lesson from October 15 however is that Treasury yields gapped down, and not up, in seven sigma moves in a perfect example that illiquidity-driven volatility could happen on lower rates as well. We could not have come up with a better example than this to drive home our most important point: it is a point of debate how far and how fast the Fed is going to be able to raise short-term rates, given the prevailing weak macro environment and a potential for negative side-effects of higher volatility. But volatility itself could, and most likely will, materialize from their attempt of doing so, even if a lesson from this experience is that six-plus years of zero rates would make it incredibly difficult to raise rates in early stages of a liftoff without disrupting the market. The point is that failure to raise rates materially does not by itself protect us from higher volatility impacting the Treasury market first and IG/HY market next. In fact such a failure would probably mean that volatility was just too high for the market and the economy to be able to cope with it.

If Deutsche Bank is right, then volatility is inevitable -- even if the Fed doesn't raise rates.