Traders Talk: Corporate Bond Liquidity

March 19, 2015

A big topic so far this year for investors has been the worrying prospect of less liquid fixed income markets, which has even led the Financial Conduct Authority (FCA) to express its concern this month in the area of corporate bonds.

Simon McGhee, head of ETF advisory at trading group Bluefin, is the first to kick off our series on Traders Talk, to explain why there is less room to manoeuvre in fixed income and what that means for ETF investors. Why is corporate bond market liquidity tightening?

McGhee: There are four reasons that spring to mind.

1) Issuance fragmenting liquidity

There are a record number of bond issues hitting the market and the liquidity is spread across an ever increasing number of securities. All things being equal, the more corporate bonds there are in existence the less liquidity there will be per individual security.

2) There’s less money to be made

Banks are more risk adverse as a result of post crisis regulation. The bond dealers within these institutions are focused on keeping their balance sheet costs down as the capital requirements are going up which in turn makes bond dealing a less profitable business.

3) Shortened settlement period

In October 2014, settlement cycles moved from T+3 to T+2 and with one less day to borrow bonds it is more difficult for dealers to sell a bond they don’t own. This is known as “going short”. Traders have to cover the short position in order to settle the short sale, so the decision becomes more skewed towards the availability and cost of borrowing bonds as opposed to having a direction view that the price will fall.

4) One way liquidity

We’ve recently seen liquidity being one directional. For example, in the last few weeks it’s been easy to buy high yield bonds due to the swathe of new issues coming to market. But if you trade against the trend in this asset class, the liquidity dries up. How does that affect ETFs and ETF trading in this sphere?

McGhee: Exchange spreads haven’t been greatly affected by the tightening liquidity as the quote sizes on screen are small but still sufficient to support retail flow.

The assets under management of fixed income ETFs is still low when compared to the size of the corporate bond markets; it’s less than 2 percent, and ETF volume / cash bond trading volume is between 1 and 3 percent.  These ratios are so low that it should be a while before ETFs start being affected by the change in the liquidity of its underlying market.


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