uploads///Investment Grade Corporate Bonds Volume and Trades

Corporate Bond Market Liquidity: Cause for Concern?

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Oct. 19 2015, Published 4:42 p.m. ET

Activity in the investment-grade market

For assessing the corporate bond market, we’ll break down our analysis into two segments, investment-grade corporate bonds and high-yield or junk bonds. The graph below shows the volume and trades in the investment-grade 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, though the rise can be safely considered gradual.

Since, for our purposes, we aren’t weighing in on the debate as to whether the corporate bond market is facing a liquidity crisis, we’ll leverage on the research of a group from the Fed (Federal Reserve Bank of New York) in order to assess the state of liquidity.

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The group

Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt of the Fed posted research entitled “Has U.S. Corporate Bond Market Liquidity Deteriorated?” in October 2015. The authors highlighted that since the secondary corporate bond market trades over the counter—unlike stocks, which are traded over exchanges—broker-dealers play a vital role as market intermediaries.

According to these authors’ research, inventories of bonds carried by broker-dealers nose-dived during the financial crisis of 2008 and have stagnated ever since. This is surprising and gives rise to worries about liquidity in the corporate bond market. It’s also surprising because even though the volume and number of trades in the corporate bond market have risen over the years, dealer inventories have fallen, which doesn’t add-up.

Liquidity not a concern

According to the group’s assessment, bid-ask spreads, which we outlined in Part 2 of this series, have narrowed, thus indicating abundant liquidity in the corporate bond market.

As far as the fall in dealer inventories is concerned, the group estimates that dealers have not remained exclusive providers of liquidity to the corporate bond market due to the emergence of other market participants like hedge funds.

A word of caution

If the group’s assessment is correct, abundant liquidity in the corporate bond market is good news for investors in mutual funds like the TIAA-CREF Bond Index Fund Retail Class (TBILX) and the Janus Flexible Bond Fund Class A (JDFAX), among others.

However, investors should keep a close eye on concerns about liquidity in the market. Historic data and analysis have no bearing on future events, especially cataclysmic ones that could suck liquidity out of the corporate bond market. Conservative and moderate investors, who are exposed to this segment, either directly (PEP) (RY) (GM), or via investment products, should be especially careful so as not to get stuck if untoward instances occur.

In the next part of this series, we’ll go further into the question of whether or not the corporate bond market is facing liquidity risk.

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