We’ve been talking about liquidity and how it happens – or doesn’t – in the markets where bonds are actually traded. This is because our immediate concern is the junk bond markets, which seem likely to be the first tripwire in the next financial crisis. We examined the current mismatch between the people who need liquidity (gigantic bond funds, e.g.) and the people who provide it – the much-diminished bond dealers.

All this was alarming on its face, but is it really something to worry about? Let’s take a look.

Unfortunately, there is no one measure of liquidity that we can assess and be comforted or terrified. I.e., there is no counterpart to the VIX, a measure of implied volatility in the equity markets.(1) Instead, if we want to understand whether liquidity in the bond markets is good or bad – deep or shallow – we have to vector in on the subject from several different directions.

Students of the bond markets measure liquidity by looking at these (and a few other) metrics:(2)

Tightness, a measure of how high or low transaction costs are, typically measured by the width of bid-ask spreads.

Immediacy, a measure of how quickly (time being money) orders can be executed and thus how efficiently trading, clearing and settlement systems are working. Immediacy can be roughly measured by the size of dealer balance sheets and by how willing the dealer market is to commit its capital.

Depth, i.e., how abundant buyers and sellers are, especially at prices close to fundamental value. Depth can be estimated by looking both at bid-ask spreads and also the ratio of buy orders to sell orders.

Resiliency, that is, how quickly order imbalances, which tend to move markets away from fundamental value, are corrected by new order flow. This metric is captured by the following straightforward equation:

Lhh = [(Pmax – Pmin)]/[Pmin/[V5-day/(MVtotal)]](3)

A few months ago Morgan Stanley published a paper in which it examined these metrics, as well as a few others (including volatility) in the high yield market.(4) Their conclusion was that while dollar and trade volumes were robust post-Financial Crisis, other metrics were more worrisome. Specifically, market turnover had declined, trade sizes were lower and volatility was higher controlling for trade size.

The paper then constructed a factor model to examine whether or not junk bond investors were being appropriately compensated for reduced liquidity. The model broke down high yield spreads into three components, default risk, market risk, and liquidity risk, and concluded that 218 bps of the total high yield spread reflected liquidity risk. And since Morgan Stanley estimated that the fair cost of the challenging liquidity environment was only about 116 bps, then, in effect, investors were actually being overcompensated for bearing illiquidity.

How comforted should we be by this analysis? Clearly, the paper was directed to a specific subset of Morgan Stanley’s customers, i.e., investors who are interested in buying and selling junk bonds but who are worried about illiquidity and whether they will be compensated for bearing that risk. Morgan Stanley’s answer was, “Not to worry.”

Obviously, under normal market conditions liquidity in the bond markets comes and goes; sometimes it’s terrific and sometimes its not. Most of the time investors are compensated for bearing illiquidity – that’s just CAPM 101(5) – although the additional yield they get fluctuates widely. When Morgan Stanley writes a carefully researched paper concluding that, sure, liquidity isn’t terrific, but, hey, you’re getting overpaid to bear it, that’s just what a bond trader wants to hear.

But other investors might be worried about something else, namely, what would happen to liquidity in the junk bond markets not under normal market conditions, but under very stressful conditions. And in this context it’s useful to remember that we’re worried about fragility in the junk markets today because of a Fed-engineered liquidity glut.

It’s not precisely an iron law of capital market investing, but it’s a damn good bet that wherever we find a liquidity glut, we will soon observe a liquidity crisis. This is because, as more and more liquidity comes into a market, investors buy more and more lousy paper and pay more and more for it. Think tulip bulbs in the shape of junk bonds.

By keeping interest rates low, and by buying massive quantities of high quality bonds via its quantitative easing program, the Fed made it very painful for investors to hold safe assets like cash and Treasuries. Unable to think of anything else to do, the ECB and BOJ did the same thing, only on a vastly larger scale relative to the size of their bond markets.(6)

Investors did what the Fed wanted them to do, selling the safe stuff and buying more and more of the risky stuff, reaching and reaching for yield until their reach exceeded their grasp. This pumped up prices of risk assets, including junk bonds, supposedly creating the “wealth effect” the Fed was seeking. People would feel richer and would spend more and the economy would grow and Fed chairs would be beatified.

Is that how it’s likely to work out? Well take a look in my next – and final – post on liquidity.

(1) The word “implied” is important. The VIX measures market participants’ expectations for volatility over the next thirty days, and those expectations can, of course, turn out to be very wrong. By the way, “VIX” is simply the ticker symbol for the CBOE Volatility Index.

(2) See, e.g., Abdourahmane Sarr and Tonny Lybek, Measuring Liquidity in Financial Markets, IMF Working Paper, December 2002.

(3) No, I don’t know what it means, either.

(4) Adam Richmond, Meghan Robson and Jeff Fong, A Premium for Liquidity, Leverage Finance Insights, Morgan Stanley, January 28, 2015.

(5) The Capital Asset Pricing Model asserts that any risk that can’t be diversified away (like illiquidity) should be compensated for by increased return.

(6) According to Deutsche Bank, the Fed’s QE program represented 86% of annual net issuance in the US bond market, the ECB’s represents 262% of annual net issuance in the euro bond market, and the BOJ’s represents (are you sitting down) 347% of annual net issuance in the Japanese bond market. As readers of this blog will not be surprised to learn, the three QE programs failed – or are failing – in inverse order as mentioned: QE failed in the US, will fail pathetically in Europe, and will fail spectacularly in Japan.

Next up: Should We Worry about Liquidity? (Part 4)

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.