Liquid, illiquid
16 October 2018
ESMA鈥檚 new working paper on liquidity in fixed income markets, which looks at the overall reduction of secondary market liquidity in recent years, has generated comment and response from the industry
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The European 色花堂and Markets Authority (ESMA) has just published a new working paper called 鈥楲iquidity in fixed income markets鈥攔isk indicators and EU evidence鈥�.
Authored by Tania De Renzis, Claudia Guagliano and Giuseppe Loiacono, the paper begins by looking at the overall reduction of secondary market liquidity in several markets in recent years, in particular, the fixed income segment.
The authors noted that market liquidity is important to ensure the efficient functioning of financial markets.
Poor liquidity is likely to impose significant costs on investors and hence, ultimately on savers and the real economy, they wrote. In the paper, the authors set out to provide a broad overview on different dimensions of liquidity in EU government bond markets and in EU corporate bond markets, covering the period from July 2006 to December 2016.
鈥淥ur findings show that having deteriorated during the financial and sovereign debt crises, sovereign bond market liquidity has increased since then, potentially also due to the effects of supportive monetary policy in recent years,鈥� they said.
鈥淗owever, we find evidence of several episodes signalling deteriorating secondary market liquidity for corporate bonds, especially between 2014 and 2016.
In the sovereign segment, market liquidity seems to be more abundant for bonds that have a benchmark status and issued in
larger dimensions.鈥�
In the corporate segment larger outstanding amounts are related to lower market illiquidity, they observed. In both segments, increased stress in financial markets is correlated with deterioration in market liquidity.
A recent European Commission study (2017) shows that an increasing number of corporate bonds are hardly traded at all, probably held in portfolios of long-term or buy-and-hold investors, they added.
Mati Greenspan, senior market analyst at eToro, a global investment platform, commented: 鈥淟iquidity in any market is an absolute essential. We try to deal in only the most liquid markets in our own particular segment, not least because when clients press the 鈥榯rade鈥� button they expect execution to take place.鈥�
鈥淭he essential economics reign irrespective of the product or commodity being traded. If you are selling apples and there is insatiable market demand for apples, you keep pushing your price up. The converse is equally true. If there is zero demand, you keep reducing your prices in response.鈥�
For Keith Ross, executive chairman of Illinois-based PDQ Enterprises, a US equity trading platform, one of the liquidity issues for bonds is around exchange-traded funds (ETFs).
As bond ETFs have been created to replicate a portfolio of bonds and its effective yield, there is a concern the rules around the requirement for actually owning the bonds to create the ETF are fairly lax and that when rates go up there will be big selling of the ETFs, he explained. That will increase the volatility of the bond market.
鈥淎nother issue for bond liquidity is the number of issues that exist,鈥� he continued, 鈥渋n addition to the numerous government issues, most companies鈥攚hich typically have only one equity stock鈥� can have many bonds. All with different interest rates and different maturities.鈥�
鈥淭here are approximately 8,000 stock issues in the US for trading; I鈥檓 guessing there are at least 10 times as many bonds. So finding liquidity in a particular issue is not trivial in the bond world.鈥�
鈥淭he good news is that bonds do mature. Unlike stocks that can go up and down for the life of the company, there is always a liquidity event at the end of the life of a bond; the company has to refinance at that time and in that process retire the bond, so there is liquidity ultimately.鈥�
He concluded: 鈥淎nother attractive thing about bonds is that one can hedge with interest rate futures, All bonds are interest rate sensitive and the correlation with futures will be stronger than with equities, so if you are in an illiquid bond you should be able to minimise your interest rate risk with a futures hedge.鈥�
Damian Billy, founder and CEO of Chicago-based hybrid investor, Econophy Group, commented that the nature of markets is that liquidity is a function of the size of the market (buyers versus sellers) and its depth, which involves buyers and sellers, that range from small to large holders of securities.
鈥淭he depth of the market is the most critical element,鈥� he added. 鈥淚f you want to sell $100,000 in bonds, not a problem. If you need to desperately sell $100 million, perhaps not so.鈥�
鈥淭hroughout the globe, central bankers in advanced countries have purposely kept interest rates low, therein artificially propping up the credit markets.
Easy credit has become a low cost and accessible addition, leading to a situation in which individual companies now have balance sheets with debt at 10 to 15 times earnings. The arithmetic itself portrays illiquidity.鈥�
鈥淒eveloped countries, including the US and entire EU market, are now so debt-ridden that their heretofore credit policies now endanger their own economic stability.鈥�
鈥淛ust like funds need to liquidate in a crisis, central bankers are not going to be so polite as to let others have an advantaged exit route.鈥�
鈥淎 realistic probability is that central banker balance sheets could experience such a severe loss they will no longer be able to issue fiat currencies to prop up a needy country.鈥�
Some might argue that his further observations border on the apocalyptic. 鈥淎s investors have piled into overvalued illiquid assets, such as bonds, the end result is that risk has been dramatically elevated for a crash type event to occur.鈥�
鈥淚f one is triggered, how liquid will the bond market be, when historically, the amount of corporate debt has soared beyond reasonable levels, as opposed to security dealer inventory being woefully less to meet the need of liquidity seekers? As witnessed before during historical equity meltdowns, bids will disappear.鈥�
Luke Hickmore, senior investment officer at Aberdeen Standard Investments in Edinburgh, is confident that such a scenario is unlikely, having lived and worked through all the major crises of the past 31 years of his professional working life.
Whereas he operates in the credit bond market, his colleagues in the UK gilts team are operating in one of the biggest debt markets in the world, in one of the largest economies in the world.
Scale, breadth and depth matter, no matter what anyone else might try to say.
Liquidity is the least of his worries, then, even in non-optimal times trading in very large amounts at very short notice. The price might move but the deal will still get done, he stated.
He has a very special word or two of advice, though, for investors who choose to invest in the illiquid paper: make sure you get paid appropriately for the illiquidity risk.
He agrees, though, that ETFs could, in theory, present a problem in the event of a run on credit and widening of spreads.
The events of 2008 and the beginning of the global financial crisis provided a taste of that, he conceded, then added: 鈥淏ut we haven鈥檛 seen an event like that since.鈥�
Authored by Tania De Renzis, Claudia Guagliano and Giuseppe Loiacono, the paper begins by looking at the overall reduction of secondary market liquidity in several markets in recent years, in particular, the fixed income segment.
The authors noted that market liquidity is important to ensure the efficient functioning of financial markets.
Poor liquidity is likely to impose significant costs on investors and hence, ultimately on savers and the real economy, they wrote. In the paper, the authors set out to provide a broad overview on different dimensions of liquidity in EU government bond markets and in EU corporate bond markets, covering the period from July 2006 to December 2016.
鈥淥ur findings show that having deteriorated during the financial and sovereign debt crises, sovereign bond market liquidity has increased since then, potentially also due to the effects of supportive monetary policy in recent years,鈥� they said.
鈥淗owever, we find evidence of several episodes signalling deteriorating secondary market liquidity for corporate bonds, especially between 2014 and 2016.
In the sovereign segment, market liquidity seems to be more abundant for bonds that have a benchmark status and issued in
larger dimensions.鈥�
In the corporate segment larger outstanding amounts are related to lower market illiquidity, they observed. In both segments, increased stress in financial markets is correlated with deterioration in market liquidity.
A recent European Commission study (2017) shows that an increasing number of corporate bonds are hardly traded at all, probably held in portfolios of long-term or buy-and-hold investors, they added.
Mati Greenspan, senior market analyst at eToro, a global investment platform, commented: 鈥淟iquidity in any market is an absolute essential. We try to deal in only the most liquid markets in our own particular segment, not least because when clients press the 鈥榯rade鈥� button they expect execution to take place.鈥�
鈥淭he essential economics reign irrespective of the product or commodity being traded. If you are selling apples and there is insatiable market demand for apples, you keep pushing your price up. The converse is equally true. If there is zero demand, you keep reducing your prices in response.鈥�
For Keith Ross, executive chairman of Illinois-based PDQ Enterprises, a US equity trading platform, one of the liquidity issues for bonds is around exchange-traded funds (ETFs).
As bond ETFs have been created to replicate a portfolio of bonds and its effective yield, there is a concern the rules around the requirement for actually owning the bonds to create the ETF are fairly lax and that when rates go up there will be big selling of the ETFs, he explained. That will increase the volatility of the bond market.
鈥淎nother issue for bond liquidity is the number of issues that exist,鈥� he continued, 鈥渋n addition to the numerous government issues, most companies鈥攚hich typically have only one equity stock鈥� can have many bonds. All with different interest rates and different maturities.鈥�
鈥淭here are approximately 8,000 stock issues in the US for trading; I鈥檓 guessing there are at least 10 times as many bonds. So finding liquidity in a particular issue is not trivial in the bond world.鈥�
鈥淭he good news is that bonds do mature. Unlike stocks that can go up and down for the life of the company, there is always a liquidity event at the end of the life of a bond; the company has to refinance at that time and in that process retire the bond, so there is liquidity ultimately.鈥�
He concluded: 鈥淎nother attractive thing about bonds is that one can hedge with interest rate futures, All bonds are interest rate sensitive and the correlation with futures will be stronger than with equities, so if you are in an illiquid bond you should be able to minimise your interest rate risk with a futures hedge.鈥�
Damian Billy, founder and CEO of Chicago-based hybrid investor, Econophy Group, commented that the nature of markets is that liquidity is a function of the size of the market (buyers versus sellers) and its depth, which involves buyers and sellers, that range from small to large holders of securities.
鈥淭he depth of the market is the most critical element,鈥� he added. 鈥淚f you want to sell $100,000 in bonds, not a problem. If you need to desperately sell $100 million, perhaps not so.鈥�
鈥淭hroughout the globe, central bankers in advanced countries have purposely kept interest rates low, therein artificially propping up the credit markets.
Easy credit has become a low cost and accessible addition, leading to a situation in which individual companies now have balance sheets with debt at 10 to 15 times earnings. The arithmetic itself portrays illiquidity.鈥�
鈥淒eveloped countries, including the US and entire EU market, are now so debt-ridden that their heretofore credit policies now endanger their own economic stability.鈥�
鈥淛ust like funds need to liquidate in a crisis, central bankers are not going to be so polite as to let others have an advantaged exit route.鈥�
鈥淎 realistic probability is that central banker balance sheets could experience such a severe loss they will no longer be able to issue fiat currencies to prop up a needy country.鈥�
Some might argue that his further observations border on the apocalyptic. 鈥淎s investors have piled into overvalued illiquid assets, such as bonds, the end result is that risk has been dramatically elevated for a crash type event to occur.鈥�
鈥淚f one is triggered, how liquid will the bond market be, when historically, the amount of corporate debt has soared beyond reasonable levels, as opposed to security dealer inventory being woefully less to meet the need of liquidity seekers? As witnessed before during historical equity meltdowns, bids will disappear.鈥�
Luke Hickmore, senior investment officer at Aberdeen Standard Investments in Edinburgh, is confident that such a scenario is unlikely, having lived and worked through all the major crises of the past 31 years of his professional working life.
Whereas he operates in the credit bond market, his colleagues in the UK gilts team are operating in one of the biggest debt markets in the world, in one of the largest economies in the world.
Scale, breadth and depth matter, no matter what anyone else might try to say.
Liquidity is the least of his worries, then, even in non-optimal times trading in very large amounts at very short notice. The price might move but the deal will still get done, he stated.
He has a very special word or two of advice, though, for investors who choose to invest in the illiquid paper: make sure you get paid appropriately for the illiquidity risk.
He agrees, though, that ETFs could, in theory, present a problem in the event of a run on credit and widening of spreads.
The events of 2008 and the beginning of the global financial crisis provided a taste of that, he conceded, then added: 鈥淏ut we haven鈥檛 seen an event like that since.鈥�
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