The International Capital Market Association (ICMA) has published its second study of liquidity in the secondary market for Europe’s investment-grade corporate bonds, which it calculates as having an outstanding nominal value of about €3.9 trillion as of June 2016.
The association defines liquidity as “the ability to execute buy or sell orders, when you want, in the size you want, without causing a significant impact on the market price”.
On that basis, based on interviews with investors, issuers, banks and broker-dealers and other intermediaries, ICMA said that “secondary market liquidity at worst remains in a state of interminable decline, and at best is becoming more challenging to provide or source”. Executing big block trades in particular has become more difficult, interviewees said.
An efficient secondary market helps issuers to price new debt and investors to work out what they should pay for a new issue, ICMA’s report notes, as well as giving investors comfort that they can sell bonds they hold easily when needed.
A credit trader quoted in the report said: “There is a view that just because the primary market seems to be functioning well, the secondary market doesn’t matter. This is dangerous thinking.”
Issuers questioned by ICMA showed a “shared concern” about the “health of the secondary market”, the report said, pointing out that a badly functioning secondary market can mean that they pay a sizeable new issue premium when issuing new paper.
In part, they blamed monetary policy and low interest rates that encourage a “search for yield” and mean that investors opt for buy-and-hold strategies while market-makers look to more lucrative work. Regulation also hampered liquidity, interviewees said, limiting firms’ ability to make markets.
In response to these problems, ICMA found that the sellside was being forced to “operate with far less balance sheet or ability to take positions or risk than at any time post-crisis”, and that trading desks were “more discerning” about which positions they took. Firms are also “reviewing and evolving their client base”, assessing a client’s relationship with the bank across other products and services.
On the buyside, ICMA found that investors are “not only being forced to find alternative sources of liquidity, but they are also learning how to create liquidity”, for example by facilitating trading between their own funds to create “internalised liquidity”.
ICMA’s report includes four recommendations that the association said could improve the situation.
The first is for regulators to provide capital relief for market-making. Next, ICMA said, measures should be put in place to boost the single-name credit default swap market, a key risk management tool for market-makers.
Third, there should be a review of regulation that could harm liquidity, ICMA said, including pre-trade transparency rules for corporate bonds under MiFID II, which the association said “has no support from any of the interviewees, with views ranging from it being completely pointless at best, to dangerous at worst”. Finally, the association has encouraged a more formalised forum in which all market participants can discuss the issues of liquidity.
ICMA carried out the interviews and surveys for its latest study before the UK’s June 23 vote to leave the European Union. The authors wrote that the leave vote “makes the findings and conclusions of this study even more relevant, as we enter a period of even greater economic uncertainty, and when market efficiency and liquidity will, potentially, be sorely tested”.
They added: “A number of participants in the study suggested that the structure of the European corporate bond markets needed rethinking and redesigning, although it would probably require a catalyst to force market stakeholders into this realisation. Whether the unfolding repercussions of the June 23 UK referendum prove to be such an impetus remains to be seen.”