Addressing Market Liquidity (BlackRock)

A Broader Perspective on Today's Bond Markets

KEYWORDS:

Authors:

BlackRock

Organizations:
  • BlackRock

Summary:

Over the past few years, much has been written about bond market liquidity. Most of the reports cite some combination of various sets of data, including: (i) the decline in broker-dealer inventories, (ii) the decline in turnover by comparing the amount of bonds outstanding to bond trading volumes from FINRA’s Trade Reporting and Compliance Engine (TRACE) in the US, (iii) the increase in corporate bond issuance, and (iv) the growth of open-end bond mutual funds. Often these reports express concern regarding what might happen when market sentiment changes. While the data cited are factually accurate and reflect structural changes occurring in the bond markets, these discussions do not present a complete picture of bond market participants or innovations that are supplementing traditional means of obtaining market liquidity. In particular, there is seldom any discussion around the myriad of unrelated investment objectives and constraints that drive bond holder behavior in disparate ways, making market participants unlikely to react to changing market conditions in the same way. Further, the dialogue has not fully acknowledged the growing role of bond exchange-traded funds (ETFs) as a source of bond market liquidity.

This ViewPoint is a continuation of previous publications addressing market liquidity and the ownership of the world’s financial assets.2Building on these reports, this paperintegrates data we have known about for a long time (e.g., bond ownership by pensions and insurers) with newer data that highlights structural changes to bond market liquidity. The purpose of this paper is not to suggest that market liquidity challenges should be ignored; to the contrary, it is imperative that market participants adapt to the changing market dynamics. That said, appropriate conclusions about systemic risks that could arise from changes to market liquidity cannot be drawn without a more complete picture of the current ecosystem. Synthesizing the new data with the old data provides a more comprehensive foundation for this discussion.

KEY OBSERVATIONS

The data shows that bond markets are undergoing a structural change to liquidity…

  1. Broker-dealer inventories have declined as dealers reduce balance sheet risk.
  2. Bond turnover (trading volume as currently measured divided by outstanding debt) has declined.
  3. Record corporate bond issuance reflects cheap money.

However, this is only a partial picture of the current fixed income ecosystem…

  1. Many asset owners have unrelated objectives and constraints that drive their behavior in disparate ways, suggesting that market participants are unlikely to react to changes in market conditions in the same way.
  2. While bond ownership by open-end mutual funds and ETFs has grown, the majority of fixed income assets are owned by other types of asset owners such as pensions, insurers, and official institutions.
  3. Liquidity is not “free”: the cost of liquidity can increase when immediacy is needed or when market liquidity is scarce. While increased liquidity costs reduce investment returns, this represents market risk not systemic risk.
  4. Market participants are adapting to changes in market liquidity and regulators are addressing liquidity risk management.
  5. Bond turnover data omits critical elements of today’s bond market structure.The growth of bond ETFs and secondary market trading of bond ETF shares are important new developments.

A more complete understanding of the fixed income ecosystem, its participants, and its ongoing evolution is needed.