By Pia Hecher.
Analyst firm TABB Group reports the number of market participants using corporate bond index futures and bond index total return swaps (TRSs) as liquidity sources is increasing as liquidity in the cash markets dries up.
In a paper entitled “The Search for Corporate Bond Liquidity: Derivatives to the Rescue?” the firm notes that liquidity, defined as “the ability to do transactions in a particular instrument in typically average size, quickly and without undue price concessions” across the life cycle of bonds is currently less than before the financial crisis in 2008, particularly evident in the case of older issues.
Tabb Group notes that asset managers may exchange cash instruments such as corporate bonds in a portfolio with derivatives. Derivatives can also function as a liquidity tool by using them as a short-term position to hedge market movement while executing a trade.
There are caveats to their use: in the case of TRSs, the instruments have to be cleared. This requirement standardises the product, a prerequisite for enough trading volume to stimulate liquidity. Clearing also makes the product easily compressible, which is a necessary precondition to use it as a short-term hedge. For corporate bond index futures and TRSs, enough market makers are needed to bring about the required liquidity.
Tabb Group admits that measuring market liquidity at any point in time is difficult; because liquidity is dynamic, it should be measured over time. Such an approach can account for the life cycle of fixed-income securities, as securities are generally more liquid immediately after they are issued. The group adds that the perceived liquidity is in part a function of price volatility. For example, if volatility is low, liquidity may seem satisfactory although there are few market makers.
In case rate volatility of corporate markets goes up in the future, the group says it is more likely that liquidity questions will arise in the more liquid segment of the market. The illiquid segment is not likely to change in a higher volatility environment since it has been a “trade by appointment” market for a long time. However, the volume of illiquid issues out for bid may change, as asset managers shorten durations and raise cash.
The increase in passive management for fixed income investment, through the use of bond indices and exchange-traded funds (ETFs) is likely to make corporate bond markets more volatile. This is because creation/redemption arbitrage is only low as long as buyers and sellers of ETF shares are more or less in balance. Any major imbalance in ETF share orders converts into price action in the underlying. If authorized participants detect an upsurge in ETF shares, they will presumably set up short or long positions in the underlyings.
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