“Has U.S. Corporate Bond Market Liquidity Deteriorated?” by Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt, NY Fed,
Commentators have argued that market liquidity has deteriorated in recent years as regulatory changes have reduced banks’ ability and willingness to make markets. In the corporate debt market, dealer positions, which are considered essential to good liquidity, have indeed declined, even as issuance and outstanding debt have increased. But is there evidence of reduced market liquidity? In previous posts, we discussed these issues in the context of the U.S. Treasury securities market. In this post, we focus on the U.S. corporate bond market, reviewing both price- and quantity-based liquidity measures, including trading volume, trade size, bid-ask spreads, and price impact.
Dealers’ Intermediation Is Key in the Corporate Bond Market
Trading of corporate bonds in the secondary market is conducted over-the-counter, with most trading intermediated by dealers. By dealers, we refer to securities brokers and dealers, which are firms that trade securities on behalf of their customers as well as on their own account. When investors want to buy and sell bonds, dealers can match offsetting orders so that they avoid holding bonds on their balance sheets, or they can buy bonds from sellers and hold them on their balance sheets until offsetting trades are found later, thus bearing the risk that prices fall in the interim. The former is called the “agency model” while the latter is called the “principal model.”
In the corporate bond market, dealers have reportedly shifted from the principal model toward the agency model in recent years, but the ability of dealers to switch trading models without affecting liquidity is limited by the market’s structure. There are tens of thousands of outstanding corporate bond issues with varying maturity, seniority, and optionality characteristics, and this heterogeneity makes it difficult to match demand and supply. As shown in the chart below, dealers’ corporate bond inventories plunged during the financial crisis and have stagnated since—mirroring the balance sheet stagnation of dealers more generally that we documented previously—and raising the question of whether liquidity provision is sufficient.
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