Shane Worner, Senior Economist, IOSCO examines the impact of asset management flows on bond market liquidity.
In the wake of the crisis of 2008, many economies implemented accommodative monetary policies to help alleviate some of the worst effects of the fallout. These accommodative monetary policies have increased the liquidity of primary market corporate bond issuances, driving down interest rates and ultimately lowering the cost of borrowing associated with corporate bonds.
However, with the US Federal Reserve signalling the normalisation of interest rates, there is continuing concern that the secondary market liquidity has failed to keep up with primary market liquidity and is prone to evaporation. Also in doubt is whether the changing structure of the secondary market will stand up in a stressed scenario. Given their importance to corporate bond markets, the driving factors behind these concerns deserve a closer look.
Secondary bond market measures
There are a number of traditional measures of secondary market liquidity including: trading volume; bond turnover ratio; dealer inventories of corporate bonds; the bid-ask spread and price impact; and data on trade size. However, many are telling an inconsistent story. Trading volumes in secondary markets have been increasing (see Figure 2), while the bond turnover ratio (BTR), on the face of it, shows secondary market liquidity declining (See Figure 3). However, the BTR is biased by a skewed denominator effect. The BTR captures secondary market turnover as a proportion of primary issuances. With record primary issuances, the data highlights that in fact it’s not a question of “less secondary market activity”, but rather of higher primary issuances that have outpaced trading.
Additionally, the decline since 2008 in dealer bank bond inventories has been citied as another indication that secondary market liquidity and the functioning of corporate bond markets have declined. Figures 4 and 5 highlight large declines in net positions since 2008. However, it is not clear from this data what proportion were corporate bond holdings. In an IOSCO research department report, Corporate Bonds: A Global Perspective, 1 the authors also noted that the data on net positions pre-2013 include other types of corporate credit, such as asset and mortgage backed securities, whose issuance declined rapidly after the onset of the crisis and as new regulations were introduced. This trend mirrored a similar decline in dealer net positions.
Economic theory would dictate that any unusual developments in secondary market liquidity should flow through to the price of executing a transaction. The bid-ask spread is such a measure, but Figure 6 shows the bid-ask spread has in fact decreased since 2008.
The age of asset management
Against this backdrop, assets under management in the funds industry have grown since the crisis of 2008.
Although growth has broadly been across all fund assets classes, in an environment of low interest rates and yield search, many illiquid asset classes, such as emerging market debt and high yield bond funds, have seen increases in assets under management, while offering daily redemption facilities. Consequently, concerns relating to potential systemic risks associated with the activities of asset managers in less liquid asset classes have been at the fore of financial stability discussions in recent years.2
The concern primarily centres on how the activities of funds will interact with potentially less liquid bond markets. In an environment of rising interest rates, bonds fund performance would suffer, due to capital losses. In response, and perceiving some so-called “first mover advantage”, unit holders will try to redeem, en masse, potentially forcing funds to liquidate their holdings in illiquid markets, amplifying price falls and thereby creating a price decline spiral. This is just one of many other plausible scenarios. Data indicates, though, that bond mutual funds generally experience greater net inflows than outflows and, as the ICI has pointed out, redemptions tend to be quite sticky, especially for retail investors.
Measuring The Impact Of Mutual Funds On Bonds
