ESMA issues working paper on fixed income liquidity
26 September 2018 Paris
Image: Shutterstock
“Having deteriorated during the financial and sovereign debt crises, sovereign bond market liquidity has increased since then, potentially also due to the effects of supportive monetary policy in recent years”, according to a whitepaper by The European Securities and Markets Authority (ESMA).
The white paper, entitled ‘Liquidity in fixed income markets – risk indicators and EU evidence’, authored by Tania De Renzis, Claudia Guagliano and Giuseppe Loiacono, discusses the overall reduction of secondary market liquidity in several markets in recent years, in particular, the fixed income segment.
De Renzis, Guagliano and Loiacono noted that market liquidity is important to ensure the efficient functioning of financial markets.
Poor liquidity is likely to impose significant costs on investors and hence, ultimately on savers and the real economy, they wrote.
The authors set out to provide a broad overview on different dimensions of liquidity in EU government bond markets and in EU corporate bond markets, covering the period from July 2006 to December 2016.
They also found evidence of several episodes signalling deteriorating secondary market liquidity for corporate bonds, especially between 2014 and 2016.
They said: “In the sovereign segment, market liquidity seems to be more abundant for bonds that have a benchmark status and issued in larger dimensions. In the corporate segment, larger outstanding amounts are related to lower market illiquidity.”
In both segments, increased stress in financial markets is correlated with deterioration in market liquidity, they added.
The authors utilised a 2017 European Commission study which showed that an increasing number of corporate bonds are hardly traded at all, probably held in portfolios of long-term or buy-and-hold investors.
De Renzis and Guagliano are both senior economists in the risk analysis and economics department at ESMA. Loiacono is a bank resolution expert and Single Resolution Board member.
Commenting on the whitepaper, Mati Greenspan, senior market analyst at eToro, a global investment platform, said: “Liquidity in any market is an absolute essential. We try to deal in only the most liquid markets in our own particular segment, not least because when clients press the ‘trade’ button they expect execution to take place.”
He added: “The essential economics reign irrespective of the product or commodity being traded. If you are selling apples and there is insatiable market demand for apples, you keep pushing your price up. The converse is equally true. If there is zero demand, you keep reducing your prices in response.”
For D Keith Ross, executive chairman of Illinois-based PDQ Enterprises, a US equity trading platform, one of the liquidity issues for bonds is around exchange-traded funds (ETFs).
He said: “As bond ETFs have been created to replicate a portfolio of bonds and its effective yield, there is a concern is that the rules around the requirement for actually owning the bonds to create the ETF are fairly lax and that when rates go up there will be big selling of the ETFs, he took the time to explain. That will increase the volatility of the bond market.”
“In addition to the numerous government issues, most companies—which typically have only one equity stock - can have many many bonds. All with different interest rates and different maturities. There are approximately 8,000 stock issues in the US for trading; I’m guessing there are at least 10 times as many bonds. So finding liquidity in a particular issue is not trivial in the bond world.”
He concluded: “The good news is that bonds do mature. Unlike stocks that can go up and down for the life of the company there is always a liquidity event at the end of the life of a bond; the company has to refinance at that time and in that process retire the bond, so there is liquidity ultimately.”
“Another attractive thing about bonds is that one can hedge with interest rate futures. All bonds are interest rate sensitive and the correlation with futures will be stronger than with equities, so if you are in an illiquid bond you should be able to minimise your interest rate risk with a futures hedge.”
The white paper, entitled ‘Liquidity in fixed income markets – risk indicators and EU evidence’, authored by Tania De Renzis, Claudia Guagliano and Giuseppe Loiacono, discusses the overall reduction of secondary market liquidity in several markets in recent years, in particular, the fixed income segment.
De Renzis, Guagliano and Loiacono noted that market liquidity is important to ensure the efficient functioning of financial markets.
Poor liquidity is likely to impose significant costs on investors and hence, ultimately on savers and the real economy, they wrote.
The authors set out to provide a broad overview on different dimensions of liquidity in EU government bond markets and in EU corporate bond markets, covering the period from July 2006 to December 2016.
They also found evidence of several episodes signalling deteriorating secondary market liquidity for corporate bonds, especially between 2014 and 2016.
They said: “In the sovereign segment, market liquidity seems to be more abundant for bonds that have a benchmark status and issued in larger dimensions. In the corporate segment, larger outstanding amounts are related to lower market illiquidity.”
In both segments, increased stress in financial markets is correlated with deterioration in market liquidity, they added.
The authors utilised a 2017 European Commission study which showed that an increasing number of corporate bonds are hardly traded at all, probably held in portfolios of long-term or buy-and-hold investors.
De Renzis and Guagliano are both senior economists in the risk analysis and economics department at ESMA. Loiacono is a bank resolution expert and Single Resolution Board member.
Commenting on the whitepaper, Mati Greenspan, senior market analyst at eToro, a global investment platform, said: “Liquidity in any market is an absolute essential. We try to deal in only the most liquid markets in our own particular segment, not least because when clients press the ‘trade’ button they expect execution to take place.”
He added: “The essential economics reign irrespective of the product or commodity being traded. If you are selling apples and there is insatiable market demand for apples, you keep pushing your price up. The converse is equally true. If there is zero demand, you keep reducing your prices in response.”
For D Keith Ross, executive chairman of Illinois-based PDQ Enterprises, a US equity trading platform, one of the liquidity issues for bonds is around exchange-traded funds (ETFs).
He said: “As bond ETFs have been created to replicate a portfolio of bonds and its effective yield, there is a concern is that the rules around the requirement for actually owning the bonds to create the ETF are fairly lax and that when rates go up there will be big selling of the ETFs, he took the time to explain. That will increase the volatility of the bond market.”
“In addition to the numerous government issues, most companies—which typically have only one equity stock - can have many many bonds. All with different interest rates and different maturities. There are approximately 8,000 stock issues in the US for trading; I’m guessing there are at least 10 times as many bonds. So finding liquidity in a particular issue is not trivial in the bond world.”
He concluded: “The good news is that bonds do mature. Unlike stocks that can go up and down for the life of the company there is always a liquidity event at the end of the life of a bond; the company has to refinance at that time and in that process retire the bond, so there is liquidity ultimately.”
“Another attractive thing about bonds is that one can hedge with interest rate futures. All bonds are interest rate sensitive and the correlation with futures will be stronger than with equities, so if you are in an illiquid bond you should be able to minimise your interest rate risk with a futures hedge.”
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