The bond market is experiencing a dichotomy that’s challenging investors, CFA Institute Magazine reported.

Post-financial crisis, the volume of outstanding bonds has grown. At the same time, however, consolidation among banks and broker/dealers has cut the number of market makers, and new regulations have reduced the capital these companies can commit to fixed-income inventories.

Matthew Tucker, CFA, managing director, head of Fixed-Income iShares Strategy at BlackRock in the San Francisco Bay Area, cites New York Federal Reserve Bank stats that these institutions currently hold 20% of their pre-crisis bond inventories. These conditions have “caused a shift in liquidity in the bond market where many investors have to reevaluate how they source liquidity [and] where they source liquidity,” Tucker told CFA Institute Magazine.

The illiquidity is greatest in markets with large numbers of outstanding securities. Tucker notes that there are approximately 250 Treasury notes and bonds with maturities of one year or greater. That relatively small (by number of issues) market has remained liquid. In contrast, BlackRock estimates that less than 20% of investment-grade corporate bonds in the US trade every day. Consequently, corporate bond investors are less likely “to be successful in finding someone to trade with and finding a price at which [they] want to transact,” he says.

A third-quarter 2016 report from Stamford, Connecticut–based Greenwich Associates, “Institutional Investors Embrace Bond ETFs,” examined the changing bond market. Per the report: “Seventy-one percent of the institutions participating in Greenwich Associates 2016 US Bond ETF Study say the trading and sourcing of securities have become more difficult in the past three years” — up from 34% the previous year. In addition, 60% of study participants reported it was more difficult to complete large-sized bond trades in 2016.

From OTC to ETF

Andrew McCollum, managing director with Greenwich Associates and the report’s author, says the liquidity problem is causing prospective investors to consider how they will sell a position before completing the buy transaction. “We have investors in our research that will say to us, ‘Today, I think very carefully not about just getting into a fixed-income security but how I’m going to get out of the fixed-income security,’” says McCollum. “And for some of these bonds that aren’t terribly liquid, they consider that when making their decision about what the right vehicle is. I don’t think that was a big consideration five years ago.”

Tucker says that illiquidity is leading bond investors to seek alternatives to the dominant over-the-counter (OTC) market structure. He estimates that the leading electronic trading platforms now handle about 20% of all corporate bond trades, and that percentage is increasing each year. Fixed-income exchange-traded funds (ETFs) are also attracting more investors. As of late 2016, the average daily trading volume in fixed-income ETFs was roughly $7 billion, and in some instances, fixed-income ETFs can supplement the corporate bond OTC market and provide additional liquidity for investors, Tucker maintains.