Senior bankers: bond market liquidity falling, partly in response to ‘regulatory reforms’

Yuliya Baranova, Louisa Chen and Nicholas Vause, who work in the bank’s capital markets division, said that recent regulatory reforms meant that dealers were no longer as likely to up their bond holdings in response to sharp changes in asset manager demand in the same way that they did before the financial crisis. Their model, which was published on the Bank of England’s new ‘Bank Underground’ blog, also demonstrated that net issuance now tends to fall in response to market shocks.

“We find that dealer holdings act less as a shock absorber than they did around a decade ago,” they wrote on the blog, which was set up to give bank staff an outlet for their views on current banking policy. “Instead, bond spreads rise more. We also find that greater declines in issuance now follow these shocks.”

“These findings support the claim that the market-making capacity of dealers has fallen in recent years, reducing secondary market liquidity,” they said.

The bankers found that dealers would increase their holdings of bonds by 1.5 basis points of outstanding market value when asset manager demand fell sharply before the crisis. Now, this has fallen to just 0.2 basis points, according to their model. At the same time bond ‘spreads’, or the premium demanded by investors to hold more risky corporate bonds rather than safer sovereign bonds, are increasing in response to market stress.

The bond market can be described as ‘liquid’ providing that investors can trade in bonds at low cost, including because their orders have little effect on the price, the bankers said. If liquidity falls, it can become more expensive for borrowers to issue bonds in the first place – which can potentially “hurt investment and economic growth”, they said.

Corporate bond assets under management have more than doubled since the 2008 financial crisis, at the same time as dealers have cut their inventories of fixed-income securities by more than 75%, according to the bankers. They said that corporate bonds could be “vulnerable to a wave of redemptions” by investors if interest rates rise and affect prices.

However, the bankers said that “other factors” including the overall decline in the market for securitisations since the financial crisis, and how uneconomical it now is to hold securities as proprietary investments as a result of new capital requirements, should also be taken into account when considering the “sharp decline” in volumes held by dealers.

Capital markets expert Grace Hui said that although liquidity in the bond markets was an area of growing concern, “the effects have not been as drastic as some have claimed”.

“The European Commission has shown its commitment to stimulating growth in this area and has recently proposed changes to boost the securitisation industry which will in turn boost the bond market,” she said.

The Financial Times reported recently that the Commission plans to table new rules on securitisation next month to the effect that banks and insurers would not have to hold as much capital in reserve to account for those debts.