Addressing Market Liquidity: A Broader Perspective On Today's Bond MarketsVW Staff
Addressing Market Liquidity: A Broader Perspective On Today’s Bond Markets by BlackRock
Over the past few years, much has been written about bond market liquidity.1Most of the reports cite some combination of various sets of data, including: (i) the decline in broker-dealer inventories, (ii) the decline in turnover by comparing the amount of bonds outstanding to bond trading volumes from FINRA’s Trade Reporting and Compliance Engine (TRACE) in the US, (iii) the increase in corporate bond issuance, and (iv) the growth of open-end bond mutual funds. Often these reports express concern regarding what might happen when market sentiment changes. While the data cited are factually accurate and reflect structural changes occurring in the bond markets, these discussions do not present a complete picture of bond market participants or innovations that are supplementing traditional means of obtaining market liquidity.In particular, there is seldom any discussion around the myriad of unrelated investment objectives and constraints that drive bond holder behavior in disparate ways, making market participants unlikely to react to changing market conditions in the same way. Further, the dialogue has not fully acknowledged the growing role of bond exchange-traded funds (ETFs) as a source of bond market liquidity.
This ViewPointis a continuation of previous publications addressing market liquidity and the ownership of the world’s financial assets.2Building on these reports, this paperintegrates data we have known about for a long time (e.g., bond ownership by pensions and insurers) with newer data that highlights structural changes to bond market liquidity. The purpose of this paper is not to suggest that market liquidity challenges should be ignored; to the contrary, it is imperative that market participants adapt to the changing market dynamics. That said, appropriate conclusions about systemic risks that could arise from changes to market liquidity cannot be drawn without a more complete picture of the current ecosystem. Synthesizing the new data with the old data provides a more comprehensive foundation for this discussion.
Liquidity In The Bond Markets – Key Observations
The data shows that bond markets are undergoing a structural change to liquidity…
- Broker-dealer inventories have declined as dealers reduce balance sheet risk.
- Bond turnover (trading volume as currently measured divided by outstanding debt) has declined.
- Record corporate bond issuance reflects cheap money.
However, this is only a partial picture of the current fixed income ecosystem…
- Many asset owners have unrelated objectives and constraints that drive their behavior in disparate ways, suggesting that market participants are unlikely to react to changes in market conditions in the same way.
- While bond ownership by open-end mutual funds and ETFs has grown, the majority of fixed income assets are owned by other types of asset owners such as pensions, insurers, and official institutions.
- Liquidity is not “free”: the cost of liquidity can increase when immediacy is needed or when market liquidity is scarce. While increased liquidity costs reduce investment returns, this represents market risk not systemic risk.
- Market participants are adapting to changes in market liquidity and regulators are addressing liquidity risk management.
- Bond turnover data omits critical elements of today’s bond market structure.The growth of bond ETFs and secondary market trading of bond ETF shares are important new developments.
A more complete understanding of the fixed income ecosystem, its participants, and its ongoing evolution is needed.
The data in Exhibits 1 through 5 have been frequently cited in reports addressing bond market liquidity. We include them here as part of the complete picture.
Many commentators have noted the reduced risk appetite of dealers post-Crisis as they re-evaluate their business models, particularly in light of the myriad of new banking regulations. Exhibit 1 shows the buildup in dealer inventories leading up to the 2008 Financial Crisis (the Crisis), and the subsequent decline in inventories since 2008. Notably, the methodology for calculating dealer corporate bond inventory changed in April 2013 to exclude non-agency MBS, which is included in the data prior to April 2013.3A Goldman Sachs analysis found that the methodology used prior to April 2013 overstates the decline in pre-Crisis inventories because it includes non-agency MBS holdings.
Exhibit 2 shows the increase in US corporate bond issuance. As you can see, issuance dipped in 2008 and has rebounded strongly in the post-Crisis years. During the Crisis, a number of companies faced a challenge in rolling over commercial paper, which has led a number of corporate treasurers to extend the term of their debt by issuing bonds to retire commercial paper. In addition, given accommodative monetary policies that have kept interest rates extraordinarily low, many companies have taken advantage of low rates to borrow cheaply. Some corporations have even used this cheap money to fund stock repurchase programs.
Exhibits 3 and 4 combine TRACE data (which captures the secondary trading volume of individual bonds in the US) with the amount of bonds outstanding to create a turnover ratio for investment grade and high yield bonds, respectively. As these charts highlight, both the numerator (secondary trading volume) and the denominator (bonds outstanding) have increased since the Crisis;however, since the amount of bonds outstanding have increased more significantly, the bond turnover ratio has declined. While this data is US-focused, European policy makers are looking to implement reporting requirements that will allow for similar data analyses in the EU. Further, the European Commission will review the functioning of the EU corporate bond markets, focusing on market liquidity and developments, as part of the ongoing Capital Markets Union initiative.
Exhibit 5 completes the current conversation by showing the growth of US open-end bond mutual fund assets under management (AUM), reflecting a variety of active and passive investment strategies including long-term, short-term, and intermediate-term bonds as well as corporate bonds, municipal bonds, and a number of other strategies.
While all of these charts provide relevant pieces of information, they reflect only a partial view of today’s bond market ecosystem, meaning that they are not sufficient to draw conclusions about risks to the financial system. Rather, they reflect structural changes to market liquidity that are encouraging market participants to evolve their technology and processes. As we described in our July 2015 ViewPoint“Addressing Market Liquidity,” BlackRock and other asset managers have been adapting to a new normal for several years. For example, we have made substantial investments to enhance our trading capabilities through building new technologies and tools and changing our behavior to help effectively obtain liquidity on behalf of our clients. Likewise, many of our portfolio managers have adapted their portfolio construction processes to account for changes to market liquidity, and our risk management team has built new tools and enhanced its monitoring of liquidity risk in BlackRock-managed portfolios. While not all market participants have necessarily made changes in recent years, there is an increasing recognition that adapting is necessary as structural changes are here to stay. Recent events have demonstrated that an inability or unwillingness to adapt and manage liquidity through thoughtful portfolio construction, robust trading capabilities, and prudent risk management can lead to problematic outcomes, particularly when managing portfolios with daily redemption features. BlackRock has advocated for changes to ensure that all market participants and the market structures that support bond markets can evolve to address these challenges. In our July 2015 ViewPoint, we recommended a three-pronged approach:
(i) Market structure modernization: Encourage evolution of market structure to better reflect current dynamics.
(ii) Enhance fund “toolkit” and regulation: Endorse best practices for liquidity risk management and expand fund toolkit to address concerns about fund redemption risk.
(iii) Evolution of new and existing products: Support the development and adoption of new and existing products that help market participants address challenges associated with changes in fixed income markets.
With respect to market structure, market participants have increasingly looked for ways to become more efficient at aggregating fragmented sources of liquidity and to find smarter solutions to execute trades. This has resulted in increased interest in electronic trading platforms and a series of new platforms have emerged, offering a variety of trading protocols.We believe the market will continue to test new platforms and that the offerings will evolve and consolidate as market participants determine the optimal trading methods and the best business models for their trading needs.
In addition to changes by market participants, policy makers are recognizing the need to study fixed income market structure. For example, the US Treasury recently issued a request for comment on US Treasury market structure. Further, regulators have taken action to enhance fund regulation. For example, European policy makers introduced rules for alternative investment funds post-Crisis. Likewise, the SEC issued a series of proposals to modernize regulations for US mutual funds to account for today’s environment. Additionally, the International Organization of Securities Commissions (IOSCO)recently reiterated the importance of having liquidity management tools available to funds and performed an analysis that compares the tools available to funds in different jurisdictions around the world.
Bond Markets – Distinguishing Market Risk from Systemic Risk
In the context of enhancing the resiliency of fund structures to account for market liquidity challenges, some observers have connected this set of issues with the potential for systemic risk to arise due to large-scale and correlated redemptions from open-end mutual funds. The concern raised is that as accommodative monetary policies are unwound, increased bond holdings by these funds could cause them to be unable to meet redemptions and potentially lead to contagion and systemic risk. While concerns about the resiliency of mutual fund structures should be addressed, it is important to distinguish market risk from systemic risk. For example, inherent in the price of all fixed income assets is the notion that obtaining liquidity from the market entails a cost –in other words, liquidity is never “free”. When market participants demand liquidity with immediacy, the cost of liquidity may be higher, particularly if immediacy is demanded during environments in which liquidity is scarce. This can lead to investment losses for some investors and, at the same time, relative value opportunities for market participants who can buy assets being sold at a discount. As we observe the beginning of the US Federal Reserve’s trajectory to move away from extraordinary monetary policies amidst significant volatility related to a variety of macroeconomic factors, it is clear that there will be many winners and losers as asset valuations change. This reflects market risk, not systemic risk.
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