Now We Have Two Answers to the ECB Corporate Liquidity Question
Has the European Central Bank created a liquidity trap for corporate bond investors?
The ECB's surprise announcement in March to extend its asset-purchase program to investment grade non-bank corporate bonds triggered a rapid, and indiscriminate, tightening of credit spreads and a jump in primary-market issuance. And that was all before the central bank purchased a single corporate bond.
Given its public entrance in the market as a large, price-insensitive buy-and-hold investor, it's no surprise, therefore, that the Corporate Sector Purchase Programme (CSPP) has, in recent months, unleashed fears of a widespread corporate-bond liquidity crunch.
These fears are by no means confined to the financial industry. Illiquid trading conditions can foster wild price movements while liquidity adds buffers. Investor fears' about their ability to make large, low-cost trades without impacting the price of the underlying asset can result in an increase in the premium demanded by market participants for purchasing and trading securities and, ultimately, higher corporate borrowing costs. Since the latter risk undermines the aim of the ECB's asset-purchase programs, policymakers have said they will seek to ensure liquidity of the marketplace is not sacrificed in the pursuit of monetary-policy objectives.
Now the ECB is in full throes of the CSPP, which began June 8, and disclosed information about its holdings on July 18, we have data to test out these liquidity fears.
Firstly, a big caveat is in order. There's no standard and objective measure of bond-market liquidity since bonds are predominately traded over the counter (OTC), unlike stocks. As a result, market benchmarks to gauge a snapshot of liquidity conditions — roughly defined as market participants' ability to buy and sell bonds, on a given stable trading day, without triggering a material shift in their price — are imperfect and subject to debate.
With the ECB permitted to own 70 percent of a given corporate issue, Bank of America Merrill Lynch analysts are firmly in the bearish camp, citing an uptick in the average bid-offer spread, which is the difference between the price quoted by a market-maker for an immediate sale of a given corporate bond and its purchase price. By contrast, IHS Markit Ltd paints a flattering picture of liquidity conditions based on broader trading benchmarks.
In short, the data don't prove the ECB has actually undermined corporate-bond liquidity.
But first, let's hear Bank of America credit analysts out.
In a research report, led by Barnaby Martin, published on Friday, the analysts write: "We fear the sheer size of CSPP buying has heightened investors' nervousness over credit market liquidity."
As evidence of the insidious impact of the ECB on liquidity conditions, the analysts chart the initial jump in bid-offer spreads in CSPP-eligible bonds after the announcement of the program; its subsequent notable improvement; its deterioration following execution of the program itself; and the ECB's disclosure to the market about its purchases through ISIN numbers, which are alphanumeric codes to identify corporate bonds.
"True, Brexit took place on June 23, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for eligible and purchased names," the analysts write.
"So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health."
On the other hand, some liquidity benchmarks, in fact, point to a slight improvement in conditions subsequent to the ECB's efforts to mop up corporate bonds in a bid to stimulate the eurozone economy.
Bid-offer spreads, therefore, only reflect the compensation dealers' demand for making the market, not the number of market-makers, with the latter seen as another indicator that sheds light on the depth of liquidity.
On this basis, there's some good news for market participants.
The average number of dealers quoting prices per bond in the iBoxx euro corporate index increased in June and July. (The constituent components are similar to Bank of America's index, and include some 3,000 bonds, including CSPP-ineligible credits.)
"The market is very focused on the bid/ask spread but that's only one component on liquidity," Simon Colvin, analyst at IHS Markit Ltd says. "We are not seeing a retreat in the number of dealers willing to make the market after the announcement, and initial execution, of the ECB's corporate bond program."
What's more, IHS Markit's liquidity-bucket data is a snapshot of conditions in the final 10 days of a given calendar month, and incorporate dealer count, bid-offer spreads and shadow liquidity, with the latter capturing consolidated trading conditions at the issuer-level. Using this data, there has, in fact, been a small uptick in bonds deemed most liquid in the iBoxx euro corporate index over the past two months, and that includes CSPP-eligible securities, according to Colville.
The role of banks as liquidity-funneling broker-dealers in the fixed-income market is severely challenged thanks partly to post-crisis regulation, a development that has received much industry and media scrutiny.
"It's hard to disentangle any cyclical reduction of liquidity by the ECB's activities from the structural reduction of bond liquidity thanks to regulation," says Russell Dinnage, consultant at capital-markets advisory firm GreySpark Partners. "However, ECB purchases could be reducing the velocity of liquidity in the market, and two-way trading flows, given the central bank's role as a buyer."
Still, while average bid-offer spreads for corporate bonds are marginally higher in June and July compared with earlier in the year, it's not clear yet that the ECB's involvement in the market has had a net negative impact on corporate liquidity conditions as a whole, when looking at broader liquidity benchmarks. That said, the size of the degree to which the central bank is crowding out would-be investors in the primary market where new-issue bonds are sold remains a matter of significant debate.
In any case, cynics might argue policymakers see bond market illiquidity as a price worth paying if the principal aim of the CSPP is, in fact, to engineer weakness in the euro.