The high volatility observed in European sovereign debt prices since the end of April has revived investor concerns regarding the market's liquidity conditions; i.e. whether large transactions can be carried out without significant impact on the price of the asset being traded. The risk is that insufficient liquidity will lead to an excessively volatile and erratic interest rate environment. Identifying which factors underlie lower market liquidity is key to determining whether this is a temporary phenomenon or a lasting source of instability which therefore needs to be watched closely or even corrected.
Two disparate phenomena have played their part over the last three years. On the one hand, financing liquidity (the ease of obtaining funds) has gradually increased thanks to central banks' ultra-accommodative monetary policies, in particular quantitative easing. On the other hand, market liquidity has diminished in several financial segments, especially secondary bond markets. On the whole the secondary market of corporate bonds has seen a larger reduction in its liquidity than its government bond counterpart, both in the US and Europe. Although bid-ask spreads for corporate bonds have historically been narrow, suggesting there are no extreme liquidity tensions, other indicators are hinting at a less encouraging diagnosis. This is the case of the ratio between daily trading volumes and the stock of debt by issuer which, in the US, has fallen by 50% since 2007 in the segment of investment grade bonds and by 30% in the speculative grade. Also revealing is the continuous drop in the average value of corporate bond transactions over 5 million dollars, from 29 million dollars in 2005 to just 15 million in 2013. Beyond these specific figures, corporate bond traders themselves are warning of a worrying difficulty in trading with debt securities due to the growing illiquidity of the secondary market. This deterioration has been less acute in government bonds but the decline observed over the last few months in the depth and breadth of secondary markets for sovereign debt from the US, Japan and Germany is a cause for concern.
Such erosion in liquidity is due to the combined effect of two big factors. Firstly, the gradual dismantling of market-making and proprietary trading activities previously carried out by large international financial institutions. New legal requirements on capital and liquidity brought in after the financial crisis have pushed up costs and consequently cut the returns from such operations. They have also depressed banks' risk appetite for accumulating stocks of bonds, traditionally a fundamental source of liquidity for the market. According to data from the Federal Reserve (Fed), stocks of corporate debt held by US banks have fallen by 80% since 2007. This reduction in the brokerage role played by the banking sector has given rise to significant changes in the kind of investor involved in the debt market with bonds managed by investment funds growing by 77% since 2007 worldwide. The second factor corresponds, paradoxically, to the very adoption of quantitative easing schemes by central banks. Such large-scale purchases have removed large amounts of public debt from the market and increased the share of buy and hold investors.
These far-reaching changes affecting the microstructure of bond markets are likely to continue in the medium term. Given this situation, the liquidity risk premia of bonds may well rise, amplifying the virulence of possible readjustments in interest rates originally brought about by fundamental forces which, in principle, would normally have a gradual effect. The abruptness of the recent sell-off of German public debt is a clear example of this circumstance. Although the tendency of liquidity to move out of reach of investors just when they need it the most is nothing new, the experience of this spring at least serves as a lesson regarding what might happen with the imminent normalisation of interest rates by the Fed.