Yuliya Baranova, Louisa Chen and Nicholas Vause.
Many investors report recent declines in market liquidity, suggesting dealers have become less willing to trade corporate bonds and other fixed-income securities due to additional costs of holding them on their balance sheets. Some fear that if asset managers began to sell these securities then prices could fall sharply. Focusing on high-yield corporate bonds, we use an econometric model to investigate whether the typical responses of dealer inventories and market prices to falls in asset manager demand have changed in recent years. We find that dealer holdings act less as a shock absorber than they did around a decade ago. Instead, bond spreads rise more. We also find that greater declines in issuance now follow these shocks.
Shrinking corporate bond dealer inventories – should we be concerned?
The market for a security is liquid if investors can trade it – even in large size – at low cost, including because their orders have little effect on its price. This matters because any decline in the liquidity of securities could make it more expensive for borrowers to issue them in the first place, and this could hurt investment and economic growth.
Several indicators of market liquidity remain healthy by historical standards. These include bid-ask spreads, price changes relative to trading volumes and price differences between frequently and infrequently traded securities or economically equivalent derivatives. Of course, each of these indicators relates to observed market activity.
However, many market participants fear that prices could move sharply under larger order flows. A particular concern is that dealers may have limited capacity to intermediate large sales of corporate bonds by asset managers, which could therefore generate sharp price falls. Assets under management of corporate bond funds have more than doubled since the 2008 financial crisis, and they may be vulnerable to a wave of redemptions if rising interest rates started to weigh on prices. Furthermore, dealers have cut their inventories of fixed-income securities by more than 75% during the same period, suggesting a significant withdrawal from market making activity.
That said, other factors may also help explain the sharp decline in dealer inventories. First, reflecting the dramatic decline in the securitisation industry since the crisis, dealers are warehousing fewer securities for repackaging. Second, as a response to the regulatory reforms, they are holding fewer securities as proprietary investments. Although these reforms apply equally to securities held as a result of market making activities, these are not necessarily kept on balance sheets for long. Hence, the level of dealer inventories could be a poor proxy for their responsiveness to market events, which is what matters for liquidity.
Modelling the impact of a fall in demand from asset managers on corporate bond market
In this blog we use a structural vector auto-regression (SVAR) model to investigate whether the typical responses of dealer inventories and market prices to changes in asset manager demand for high-yield corporate bonds have changed in recent years. We also use this model to investigate whether the response of issuance has changed. The model is