The lack of corporate debt liquidity is certainly worrisome—indeed, it is one of a myriad of similar potential trouble spots—and has some idiosyncratic elements investors should take into account. Observers have been warning of a potential crisis in corporate debt since the 2010 passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act, which among other things has sharply curtailed the amount of bond “inventory” held by Wall Street dealers, even as investors have piled into ETFs and other investment structures that offer daily (or even instant) liquidity on what can be very illiquid assets. The worry is that when another crisis hits and investors look to sell, no one will be there to buy.
We penned a brief last September (“Corporate Bonds: The Next Liquidity Crisis?”) that made many of these points, and agree the current structure of the market is problematic; basically, at some point there will come a “bids wanted” situation in which investors look to sell and there is a dearth of buyers. However, is this really different from any number of other asset classes (e.g., equities) investors have piled into despite real and quantifiable worries (e.g., valuations approaching historical extremes) due to a belief that central banks “have their back”? The corporate bond market is unbalanced and susceptible to an exogenous event—or even just a sustained bout of selling—but it’s hard to believe, given the experience of the financial crisis, that central banks would simply sit back and watch the market implode.
Much of the recent chatter about this issue seems to have been sparked by a March paper from the Bank for International Settlements (BIS) warning about risks.* However, in our view the most interesting part of the paper was its explicit endorsement of central bank intervention in the event of “stressed environments.” While we mooted this issue in our paper (and are hardly the only ones to do so), it is noteworthy to see the BIS endorse such measures. In their words:
More direct central bank interventions in securities markets could include outright purchases and sales of securities to support the functioning of particular markets that are judged as critical to financial stability. These measures, which would be considered only once other measures have been exhausted, are sometimes referred to as “market-making of last resort.”
Such measures, of course, would hardly be a surprise in a world in which an increasing number of central banks now openly buy equities, but there may be another lesson to be drawn from this statement. Specifically, the phrase “particular markets that are judged as critical to financial stability” could be read as referring to the corporate bond market as a whole or to the debt of institutions judged critical to market stability (e.g., banks).
Since central banks cannot feasibly buy all corporate debt in a crisis given the sheer number and variety of securities, their most likely course of action to stabilize the market would be to buy sizable chunks of large, “significant” issues (or perhaps “encourage” certain large banks or money managers to do so). Such actions, of course, might have little or no impact on less-liquid issues, and thus corporate debtholders worried about this issue might consider tilting holdings toward institutions likely to be considered “critical to financial stability,” and as such first in line for a bailout.
In sum, the lack of corporate debt liquidity is certainly something to worry about … along with a number of asset classes where investors seem to be similarly blasé about substantive risks. Investors with (or considering) an allocation to corporate debt should therefore assess it critically, particularly in the case of smaller, less-liquid issues.
* Ingo Fender and Ulf Lewrick, “Shifting Tides – Market Liquidity and Market-Making in Fixed Income Instruments,” BIS Quarterly Review, March 2015.
Eric Winig is a Managing Director on the Cambridge Associates Global Investment Research team.