Bond market liquidity’s importance
Like markets of other financial products, liquidity in bond markets is crucial because this market provides a big source for the government and corporates to raise money for their projects and ventures. A liquidity squeeze in bond markets can quickly dry up a large financial resource, especially for corporates, who cannot resort to printing currency like the government.
When investors are deciding upon the appropriate coupon on a bond that will compensate them for the risk they’re taking—especially for high-grade and high-yield corporate bonds—liquidity premium plays an important role, and not just for what’s being compensated. We also have to take into account the time value of money, interest rate risk, and credit risk.
The liquidity premium represents the compensation that investors think is appropriate, given the difficulty they see themselves facing when selling the bond prior to its maturity. A high liquidity risk premium is one of the reasons that high-yield bonds (TIYRX) have a higher coupon set on them than high-grade bonds (PINCX).
A liquidity squeeze would thus make issuing bonds difficult for companies because a rise in the liquidity risk premium would lead to a rise in the coupon required by investors. This raises the borrowing cost for a company.
In recent times, a run-up in high yield or junk bond yields has led to issuers like Altice NV, which raised high-yield bonds in order to fund its acquisition of Cablevision Systems Corporation (CVC), to pay coupons above 10% to investors. Other issuers who have paid similar high coupons are Olin Corporation (OLN), Post Holdings (POST), and Frontier Communications Corporation (FTR).
This is not to say, however, that there’s currently a liquidity squeeze in that market—necessarily. High yields have a lot to do with the size of the issues and concerns regarding the finances of the companies in question as well. But we can say that if liquidity gets worse, coupons on these issues move even higher than was set on these issuers’ bonds.
The direction of the Treasury
But the reason bond market liquidity has been making headlines is not limited to corporate bonds. Institutions and market participants have expressed worries that the US Treasury market is heading for a liquidity squeeze. This is a worrisome thought because the ~$13 trillion Treasury market should not face such issues of high bond demand at most times.
There’s also been a big debate regarding regulations that could potentially cause a liquidity crunch in the future. We’ll go deeper into this issue in the next part of our series.