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Assessing Liquidity Risk in the Corporate Bond Market

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Activity in the high-yield market

In the preceding part of this series, we looked at trading volume in the investment-grade segment of the corporate bond market. Now we’ll shift our focus to the high-yield or junk bond market. The graph below shows the volume and trades in the high-yield segment of the corporate bond market over the past nine years. Please note that these metrics are only for publicly traded bonds.

The graph shows that there has been a rise in both metrics over the past few years, but similar to the investment-grade segment, the rise can be considered as gradual.

In the preceding part of this series, we looked at the status of liquidity in the corporate bond market through the eyes of a research group at the New York Fed. In this part, we’ll shift focus to liquidity risk in the corporate bond market.

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The group

Tobias Adrian, Michael Fleming, Or Shachar, Daniel Stackman, and Erik Vogt of the Federal Reserve Bank of New York posted research entitled “Has Liquidity Risk in the Corporate Bond Market Increased?” in October 2015. The research group estimated that there is abundant liquidity in the corporate bond market. But the question remains as to whether our worries should be about liquidity levels or liquidity risk. For assessing this, the group created an illiquidity index.

Little liquidity risk

According to the group’s illiquidity index, “corporate bonds are quite liquid by historical standards.” Further, liquidity risk has fallen from the levels seen during the financial crisis of 2008. Importantly, their research also showed that since 2011, liquidity risk for Treasuries has increased while that of the corporate bond market has decreased.

However, as noted previously in this series, historical analysis is not a precursor of future events. The corporate bond market, which trades over the counter, is generally estimated to be at a higher liquidity risk in events like a rate hike, especially at a pace that is unexpected, compared to Treasuries.

Investors in corporate bonds (PETM) (SFTBY) (WPX) and related mutual funds like the Janus High Yield Fund Class A (JHYAX) and the TIAA-CREF High Yield Fund Retail Class (TIYRX) should take note of the fact and not find themselves in a situation where their investments are in lockdown. Rebalancing would be a wise thing to do if you either require the money or feel jittery at the prospect of rising liquidity risk.

In the next part of this series, we’ll look at why bond mutual fund investors could be at risk in the case of a liquidity crisis.

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