I tend to disagree with the following assessment of liquidity and the impact of shrinking dealer balance sheets and risk tolerance, but this is just borne of my experience in the credit markets over the last couple of decades. It is, in my opinion, harder to transact and dealer positions are more limited. looking at bid/ask spreads of go-go bonds doesn't quite give on the feel for liquidity when one is looking to establish/exit a position (strip out financials and see how you do). That said, I am not sure one can say "liquidity is lower". Rather, "liquidity costs more" might be a better way to put it. There is an increased cost of risk in the "new world".
Thoughts?
FRBNY has posted a new article on their Liberty Street Economics blog entitled "Has U.S. Corporate Bond Market Liquidity Deteriorated?" The following are some highlights:
- Trading volume has risen over time, especially since the financial crisis, but at a slower rate than debt outstanding. It follows that turnover rates-the ratio of trading volume to debt outstanding-for corporate bonds have declined, which is often pointed to as evidence of reduced liquidity.
- average trade size has declined since the crisis. Some market commentators see this trend as evidence that investors find it more difficult to execute large trades and so are splitting orders into smaller trades to lessen their price impact.
- Since the Financial Industry Regulatory Authority (FINRA) introduced its Trade Reporting and Compliance Engine (TRACE) in 2002, corporate bond bid-ask spreads have narrowed. This trend was interrupted during the 2007-2009 financial crisis, but resumed afterwards. The current level of bid-ask spreads is even lower than pre-crisis levels.
- [trade] price impact has been declining since the crisis and is now well below pre-crisis levels.
In conclusion, the price-based liquidity measures-bid-ask spreads and price impact-are very low by historical standards, indicating ample liquidity in corporate bond markets. This is a remarkable finding, given that dealer ownership of corporate bonds has declined markedly as dealers have shifted from a "principal" to an "agency" model of trading. These findings suggest a shift in market structure, in which liquidity provision is not exclusively provided by dealers but also by other market participants, including hedge funds and high-frequency-trading firms.