There have been growing concerns over the decline in the bond inventories held by dealers and the liquidity implications within bond markets. Though some of the increased risks may be exaggerated it serves to reinforce how investors should view liquidity within the corporate bond market with caution.
What role do dealers fulfill within fixed income markets?
Unlike the stock market where securities trade on exchanges, most bonds trade in an over the counter market (“OTC”) which makes the role of the bond dealer more important. In an OTC market an investor looking to trade a bond typically contacts a bond dealer, who will either (a) find a third party with which to trade or if a third party cannot be found to trade with (b) step in and hold that bond on its books until a third party can be found. To facilitate this role as a provider of market liquidity it’s important for dealers to maintain an inventory of bonds on their balance sheet. Due to the dealer’s role in overcoming the timing mismatch between buyers and sellers, they have been an important source of liquidity and price discovery within bond markets.
How has the environment for dealers changed?
The last decade has seen a material decline in the inventories held by bond dealers as evidenced by the US dealer market. The magnitude of the decline is evident in Figure 1. Driving this decline is a range of factors, some of which are behavioural and others associated with regulatory changes. The cumulative impact has been that the inventories held by bond dealers has declined materially as the cost of providing market making services has increased.
The decline in inventories is even more pronounced when compared to the increase in trading volume within credit markets. At a time that dealer inventories have declined by 75% from 2008 highs the turnover in the US corporate bond markets has risen by around 30%-40% (see Figure 2).
Fewer dealers means higher volatility
The reduction in the ability of dealers to act as liquidity providers has the potential to remove one of the market’s shock absorbers against abnormally large trades flowing onto the market. With lower inventories dealers will have a reduced capacity and/or risk appetite to act as intermediaries. The result could easily be an increase in volatility associated with bond markets. By implication bond portfolios could be more susceptible to what may be referred to as “mini corrections” associated with abnormally large market flows. The flow on impacts from these “mini corrections” could be more severe market selloffs than are warranted by fundamentals as the liquidity premium attached to bonds is increased when investors realise that they cannot exit securities when they want to.
The potential impact on volatility in Australia may be more muted
While the decline in dealer inventories is a negative for market liquidity and has increased trading costs, the impact on Australian markets may be more muted. Behind this is that, unlike in the US, the level of turnover in Australian bond markets has declined rather than increased. With such a decline in bond turnover the decrease in dealer inventories is likely to have had a less significant ‘day to day’ impact on liquidity (see Figure 3).
Though the decline in turnover may appear to be good news, it in turn reflects a material change in investor behaviour within the Australian corporate bond market. Driving this decline in turnover is the impact associated with more local investors appearing to adopt a longer term ‘buy and hold’ approach to management. Part of this change in behaviour may have been driven by the increase in trading costs associated with reduced activity by dealers. More importantly, in contrast to other markets such as the US, the relatively low issuance of new corporate bonds in Australia has seen investors loath to sell out of physical bonds unless necessary as demand outstrips supply. Not only has this reduced turnover in physical bonds but it has also meant that derivatives markets are being increasingly utilised to implement changes within portfolios. Though market makers have withdrawn or reduced activity in bond markets globally, the overall decline in turnover means that there is less need for them to act as liquidity providers and hence a more muted impact on volatility in Australia.
Do dealers come to the rescue in a stress situation?
Even without the decline in turnover one should not overplay the historical role of market makers as stabilisers in stress situations. Under “normal” market conditions dealers can function very effectively as liquidity providers but their ability to facilitate this role is seriously compromised during periods of stress when they risk being swamped by investor selling. In such situations, when there is a mass exit from bond markets, dealers may actually cease to provide market liquidity because there is no longer the expectation of buyers on the other side to match trades against.
This behavioural bias of dealers is highlighted in Figure 4 by the bond market selloff of 1994 (green), financial market turmoil of 1998 (purple), financial crisis in 2008 (yellow) and 2013 (red). In all cases where there was a material selloff in bond markets, dealers materially cut their positions. History suggests that when a major selloff is going to occur in a bond market, irrespective of whether dealer inventories are large or small, dealers will reduce their exposures to the bond market at the same time as everyone else.
A lot of attention has been focused on the decline in dealer inventory and the potential that this will exacerbate market selloffs. These concerns do appear to be overblown due to local dynamics and the fact that dealers generally do not act as stabilisers in stress situations. The changes in dealer and investor behaviour does highlight that the trading costs for bonds, and particularly corporate bonds, has increased. This suggests that it is best to adopt a ‘buy and hold’ mentality and not to assume that liquidity will be there when you want to sell as it may not be. If part of your portfolio is required to provide liquidity invest in shorter duration government bonds but don’t assume that you can have ‘your cake and eat it’; i.e. earn the higher yield from corporate bonds as well as having liquidity when you need it. This was true before the decline in dealer inventories and has only been reinforced with the change in dealer dynamics and investor behaviour over the last decade.