June 21, 2019

IOSCO published a report that examines the factors affecting liquidity, under stressed conditions, in the secondary corporate bond markets. The report notes that changes in the structure of secondary corporate bond markets have altered the way that liquidity is provided in these markets. These changes result from things such as post-crisis regulations that have reduced the capacity of intermediaries to provide liquidity in secondary corporate bond markets, greater risk aversion on part of intermediaries, gradual introduction of electronic trading, and significant growth in the size of these markets resulting from central banks’ quantitative easing policies and low rates of return on other financial assets.

The report is prepared by an IOSCO committee on emerging risks. The findings of this report are drawn from a review of the literature on liquidity in corporate bond markets under normal and stressed conditions, an examination of past episodes of stress in corporate bond markets, and discussions with a broad range of industry stakeholders. The key findings of the report include:

  • The structure of corporate bond markets has evolved since the financial crisis, driven primarily by changes in the behavior of market intermediaries and in the supply of and demand for corporate bonds.
  • A reduction in the capacity and desire of dealers to participate in corporate bond markets as principals could mean that future movements in bond prices in times of stress will be more acute than before.
  • Several characteristics of corporate bond markets should reduce the risk that strong price movements in bond markets will generate broader economic stress. These include effective liquidity management by issuers of corporate debt, reduced leverage and fewer leveraged players in the market than before the financial crisis, and the low frequency with which many corporations enter primary bond markets for financing.
  • The willingness, resources, and ability of market participants to provide sufficient demand-side liquidity to help stabilize markets will be critical factors in determining how corporate bond markets operate under stress.
  • Mutual funds are unlikely to be a source of either considerable selling or price volatility under stress, particularly those funds with managers who have instituted strong liquidity management processes, including plans for operating under stressed conditions.

Overall, significant structural changes that have taken place in corporate bond markets since the 2008 financial crisis and the ensuing financial reforms have likely reduced the ability of traditional liquidity suppliers to lean against the wind. Intermediaries reduced their supply of liquidity and increased the number of agency-based transactions they conduct for their clients relative to the principal-based transactions, in both normal times and times of stress. On the positive side, asset managers, including managers of mutual funds, appear to recognize the problem and believe they have liquidity risk management arrangements that should allow them to handle an increase in redemption requests from their clients, without having to conduct ‘fire sales’ of their corporate bond assets.

 

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Keywords: International, Banking, Securities, Post-Crisis Regulation, Corporate Bonds, Market Liquidity, Liquidity Risk, IOSCO

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