In March 2022, the US Federal Reserve began a campaign of aggressive interest rate rises. It was intended to combat spiralling inflation — but it had a secondary effect: reducing liquidity, or the ease and speed with which investors could trade assets. That added risk not only for bondholders but also for investors in companies reliant on bonds.
As the Fed signalled more rate rises in the future, the appeal — and the price — of existing fixed-income securities diminished further, creating a mismatch of buyers and sellers.
And, as the yields on government and corporate bonds marched higher, companies shied away from issuing new debt, fearful of locking in expensive borrowing costs.
Then, in March 2023, big losses on bond investments, and a loss of investor confidence, led to both Silicon Valley Bank and Signature Bank failing over the same weekend.
Now, just over a year later, the banking sector concerns have eased. The Fed has kept interest rates on hold for nine months in a range of 5.25 to 5.5 per cent, with no further increases since last July. As a result, companies have rushed back into the debt market, using a period of relative calm to issue a record amount of new dollar-denominated bonds at the beginning of 2024.
However, periods of market stress over the past couple of decades — from the global financial crisis, to the coronavirus pandemic and more recent challenges pertaining to tight monetary policy — have prompted much greater scrutiny of liquidity risk by traders, analysts, and regulators.
“Liquidity is always one of my biggest concerns,” says John McClain, portfolio manager at Brandywine Global Investments. “Let’s not forget, just a few years ago, what things looked like during Covid: I think there were liquidity stress points across almost every asset class.”
The $26.5tn US Treasury market is the deepest and most liquid in the world, and is the central tool used by the Fed to control monetary policy. But that status as the bedrock of the global financial system is one of the reasons why regulators have been so focused on the market’s liquidity and eager to discuss big changes to its function.
Concerns about liquidity in the Treasury market have stemmed, in part, from its enormous growth: it is now roughly five times its size in 2008, which makes it more difficult to find enough buyers to match sellers, even as the number of intermediaries has increased.
Among those newer intermediaries are a number of hedge funds and high-speed trading firms. But debate has persisted about the quality of the liquidity provided by some of these organisations, due to their lack of transparent trading information, compared with banks. One major worry is that some funds provide liquidity via leveraged trades — a dynamic that can compound problems in periods of stress.
While some reforms are still under discussion, the Securities and Exchange Commission passed a new rule in December to push more Treasury trades through central clearing houses, which means deals are collateralised with cash.
The SEC also passed the so-called ‘dealer rule’ in February, which will force high-speed trading firms, and possibly some hedge funds, to register as dealers, which would have the effect of boosting transparency.
Another key reason for perennial scrutiny of the Treasury market is that it is used as a risk-free benchmark to price many other types of securities — including corporate bonds.
“If . . . a dealer who is hedging out their rate risk can’t do that, because they can’t find liquidity in a US Treasury, it’s also very hard for them to provide liquidity in a corporate bond,” points out Izzy Conlin, head of US institutional credit at Tradeweb.
Still, some market participants say the expanding footprint of systematic and high-frequency trading firms has helped to bolster the liquidity of the US corporate bond market, improving price discovery — just as banks, the traditional liquidity providers in this arena, have pulled back following regulatory changes after the 2008-09 global financial crisis.
At the same time, the proliferation of fixed income exchange traded funds and the rise of portfolio trading — wherein several bonds can be priced and traded as one package — are deemed, by some, to have improved the ease and cost efficiency of buying and selling corporate debt.
But some shifts in the corporate bond landscape have sparked further questions on liquidity risk. McClain notes: “There’s definitely a mismatch with intraday liquidity of ETFs, or daily liquid mutual funds, and many of the asset classes that are being invested in fixed income.” This can “create a lot of opportunity” for traders, he adds, but can also be problematic for market functioning.
By and large, though, market observers say that bond markets appear liquid and relatively stable right now.
Even so, Bhas Nalabothula, Tradeweb’s head of US institutional rates, senses that concerns could start to creep in again. “I don’t think people are necessarily complacent,” he says, but “I do think people are nervous — between geopolitics, the [US] election, macro-uncertainty, with inflation and . . . the potential outcome for rates to go higher. We weren’t necessarily having that conversation a month-and-a-half ago. People are on their toes.”
