By Terry Flanagan

Bond Markets Continue to Face Liquidity Crunch

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As the fixed income market continues to become more automated to address these pressures, the ability to access streaming evaluated price information that is updated continuously throughout the day based on multiple inputs will become more important in the creation of a liquid, vibrant market.

“Regulatory mandates, risk-based capital requirements and market evolution have created a fixed income market with new questions, concerns and opportunities,” said Bill Gartland, senior director of evaluated pricing services at Interactive Data. “There is an increased emphasis on market transparency and a focus on market structure from regulators and market participants alike.”

A research paper published by BlackRock in September 2014 “underscores the need to create a bond market that is capable of dealing with the shift in balance sheets to facilitate large orders,” Gartland added.

While structural changes in the provision of market liquidity are not fully understood, financial stability analyses in recent years have noted the potential fragility of market liquidity during a market shock, due in part to the reduced willingness or capacity of broker-dealers to provide liquidity, according to the Office of Financial Research.

“Recent market dislocation showed those concerns to be valid, as market liquidity quickly vanished in traditionally liquid markets such as U.S. Treasuries, cash, and futures markets, leading to less market depth and further sharp price declines,” the OFR said in its 2014 annual report. (Reduced market depth increases the transaction cost of executing a trade in reasonable size.)

Although indicators do not show excessive concern about market liquidity, signs are emerging that market liquidity has become more fragmented in a few markets since the crisis, said the OFR. Large broker-dealer inventories have shrunk, inventories have grown more concentrated in high-quality liquid assets, and dealer willingness to buffer periods of intense selling pressure has been more limited.

Trading volumes have declined despite increased inflows (for instance, in emerging market sovereign bonds and U.S. corporate bonds), leading to depressed turnover in secondary markets. Trading activity is concentrated in the primary new issue market or in a small number of credits in U.S. and emerging market corporate bonds, suggesting reduced market depth, the OFR noted.

Also, the size of an average trade has declined in both high-yield and investment grade corporate bond markets, and spreads for newly issued bonds have widened relative to older benchmark bonds for the same maturity in some asset classes.

Featured image via shyshka/ Dollar Photo Club

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