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Why Liquidity Matters in the Corporate Bond Market

KEY TAKEAWAYS

  • A corporate bond’s liquidity largely influences its ability to make large-scale, low-cost asset trades without causing large price changes. 
  • Researchers have found that strong links exist that tie systematic liquidity risk to the the pricing of securities in the corporate bond market. 
  • Research suggests that illiquidity can substantially impact yield spreads, which significantly widen during times of market volatility.
  • Bonds that carry AAA ratings are better able to weather periods of financial stress than other bonds.
  • The majority of corporate bond investments are made by institutional investors because retail investors often lack access to these opportunities, or the necessary capital.

Common (Systematic) Liquidity in the Market

Evidence presents a strong connection between systematic liquidity risk (aka common liquidity risk) and the pricing of securities in the corporate bond market. Evidence also indicates that illiquidity can materially affects yield spreads, which dramatically widen during times of market volatility. In fact, a study conducted by Friewald et al. (2012) found that liquidity accounts for up to 14% of a corporate bond’s yield during tranquil markets, but spikes to nearly 30% during recessions and other times of financial stress. Interestingly, this phenomenon holds true for all bonds, except for those rated AAA.

Broadly speaking, the liquidity of all corporate bonds fluctuates, especially during shaky economies. But various classes of corporate bonds respond differently to illiquidity shocks, largely depending on their credit ratings. While AAA bonds respond positively, higher-yielding, lower-rated corporate bonds fare poorly. In stable markets, the determinant liquidity factors tend to be idiosyncratic, based on the behaviors of each individual issuer.

The Bond’s Specific (Idiosyncratic) Liquidity

Heck et al. identified a significant relationship between yield spreads and bond illiquidity. Their study specifically found that idiosyncratic behavior exhibited by the liquidity of some corporate bonds may be simply due to the closed nature of the market, where investors are unlikely to invest in the bonds, either because they are unaware of their existence, or because they are forbidden from accessing them.

In many cases, individual/retail investors lack the funds necessary to invest in the bonds that carry high denominations of $100,000 or more. These high figures tend to thwart their ability to incorporate such corporate bonds into their broadly-diversified portfolios.

When comparing different types of corporate bonds, Heck et al. also found that both shorter-term and higher-yielding bonds experience greater susceptibility to such idiosyncratic illiquidity.

The Bottom Line

Numerous studies have demonstrated that illiquidity is priced in corporate bond yields. Hence, liquidity significantly influences the corporate bond market and should be closely monitored by both private and institutional investors. Liquidity risk is a highly complex subject matter that requires in-depth professional analysis.

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