Liquidity is a cornerstone of the efficient functioning of financial markets. The European Securities and Markets Authority (ESMA) published a working paper in September 2018, examining liquidity in European Union (EU) fixed income markets, with a specific focus on EU sovereign and corporate bonds.1
The paper reported that sovereign bond market liquidity was 'relatively ample' over recent years, in part due to the effects of supportive monetary policy. However, the report noted that secondary market liquidity for corporate bonds deteriorated when market conditions declined during the same period. The paper concludes that market liquidity in fixed income markets is negatively impacted when financial markets are under stress.
Key insights
- In a study of market liquidity, ESMA found that liquidity differs significantly between sovereign and corporate bonds—with sovereign bond market liquidity recently increasing while corporate bonds have seen several episodes of deteriorating secondary market liquidity during periods of financial market stress
- The impacts of monetary policy on credit markets may elevate risk if investors respond by moving strongly into overvalued illiquid assets, such as corporate bonds, meaning asset managers need to ensure they are compensated appropriately for any liquidity risk
- The rise of bond ETFs in response to shifting markets in the post-crisis regulatory environment may produce increased volatility in bond markets, which asset managers may need to address through hedging through the use of derivatives
ESMA concluded that episodes of short-term volatility and financial market stress over the past few years have raised concerns about the worsening of secondary-market liquidity for EU fixed income, leading to questions about the functioning of this segment.
Post-crisis regulatory environment driving demand for high-quality liquid assets
The role of ESMA, established in 2011 as one of three supervisory authorities within the European System of Financial Supervisors, is to provide microprudential monitoring and assessment of trends, potential risks, and vulnerabilities in the field of securities, legislation in order to safeguard the functioning of financial markets in Europe at the EU level. ESMA's study of risk indicators and evidence in EU fixed income markets, as summarized in the working paper, was undertaken in fulfillment of that role and studies the recent shifts in the fixed income environment.
“The financial crisis changed the way the world thought about liquidity," comments Rob Pomphrett, Managing Director, Global Head of Treasury & Market Services and Head of Financial Resource Management, RBC Investor & Treasury Services.
This sentiment is echoed by Mati Greenspan, senior market analyst at global investment platform eToro. “The 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."2
Increased stress in financial markets correlated with deterioration in market liquidity
One of the background factors driving overall liquidity in fixed income markets since the financial crisis has been the role of central bankers in many countries in holding interest rates low and shoring up credit markets.
The financial crisis
changed the way the
world thought about
liquidity
Damian Billy, founder and CEO of the hybrid investor Econophy Group, comments that “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."3
The ESMA paper notes that if, in response to an environment of rising interest rates, investors move strongly into overvalued illiquid assets then risk is elevated should a crash occur. Specifically, the paper notes that “with reference to corporate bond markets, the sensitivity of bond liquidity to bond-specific and market factors is larger when financial markets are under stress...This empirical result is consistent with the market liquidity indicators developed for corporate bonds pointing at episodes of decreasing market liquidity when wider market conditions deteriorate." In both the corporate and sovereign bond markets, the working paper observes that “increased stress in financial markets is correlated with deterioration in market liquidity".
ESMA measured liquidity across five dimensions
- Tightness: the possibility of executing transactions at a low cost
- Immediacy: the speed at which orders can be executed
- Depth: using order-level data (refers to the existence of enough orders at prices above or below market price)
- Breadth: the ability to transact large volumes with a minimum impact on prices
- Resilience: the availability of liquidity in periods of higher volatility and market stress
“The question on the table is how liquid the bond market may be when the amount of corporate debt is at record highs," says Pomphrett. “The EMSA working paper points to lower liquidity resilience in EU corporate bond markets. This issue is one that market analysts will continue to track closely as the structural changes affecting bond markets in the wake of the global financial crisis continue to unfold, a decade on."
Bond ETFs: Will a rising rate environment boost volatility in bond markets?
Another issue that poses challenges in respect of bond liquidity is the rise of exchange-traded bond funds (ETFs), which are created to replicate a portfolio of bonds and its effective yield. As bond ETFs may not be required to own the bonds used to create the ETF, a rising rate environment may lead to increased selling of ETFs and heightened volatility of the bond market.
Increased stress in financial markets is correlated with deterioration in market liquidity
Bond liquidity is also impacted by the number and range of instruments available in the market, with varying rates, payment terms and maturities which can pose challenges in matching supply and demand efficiently.
The ESMA working paper provides insights into the functioning and potential future direction of the EU corporate and sovereign bond markets. Market analysts and other participants, such as regulatory oversight bodies including ESMA, continue to track market liquidity to help ensure the effective functioning of fixed-income markets both within the EU and globally.