Corporate bond markets are beginning to adapt to the post-crisis world, which will result in returning liquidity, according to research by the International Organization of Securities Commissions (IOSCO).
It found that pre-crisis liquidity in corporate bonds provided by banks was at least partly facilitated through excessive leverage and risk mismatch activities, which IOSCO classes as “phantom liquidity”.
Factors since the financial crisis have contributed to less phantom liquidity in the market due to regulation and better internal risk controls at banks.
But bondholders have faced increased liquidity risk as these same banks are much less willing to provide liquidity. IOSCO points to a reduction in dealer inventories at a time when corporate bonds outstanding have expanded rapidly.
In particular, banks have shifted away from corporate bonds towards credit default swaps, which are cheaper, allow for hedging strategies and have an equivalent pay-off structure to physical bond holding.
This increased liquidity risk is largely of concern for bond funds, as buy-and-hold strategies are less sensitive to a loss of liquidity in the market. IOSCO said there is a risk that retail investors in bond funds, faced with falling yields due to increase liquidity risk, may exit the market en masse, hurting the already fragile secondary market, which would ultimately increase the cost of financing for businesses that rely on the bond market.
It said the introduction of multi-dealer electronic trading platforms could inventivise new trading parties, including the buy-side and non-primary dealers to fill the gap left by banks, but the development of these platforms is still at an early stage. However, initial signs have been positive, as the secondary market has already absorbed the effects of the bond sell-off seen in 2013 when the US Federal Reserve hinted that it would look to begin winding down its quantitative easing program. IOSCO said this strongly suggests the transformation of the corporate bond market away from bank dealers is already underway and able to cope with stresses in the market.
The report called for further research on the loss of phantom liquidity and the impact of new trading platforms in the corporate bond market to assess whether the market was still able to meet the financing needs of the real economy and cope with larger stresses than seen last year.