Why Liquidity Matters in the Corporate Bond Market

A corporate bond’s liquidity can be understood as its ability to make large-scale, low-cost asset trades without a noticeable impact to its price. Clearly, the significant determining factors for this are the volume, time and cost associated with the trade.

The relationship between a bond’s liquidity and its yield spread has, rightfully, been a subject of much research. A wealth of empirical evidence suggests some such relationship or commonality exists, as well as evidence that premiums connected to liquidity risk exist.

Studies, among others, which have been dealing with this encompass Chordia et al. (2000) and Hasbrouck & Seppi (2001). In particular regarding the influence of liquidity in the corporate bond market recent studies have been conducted by Lin et al. (2011), Bao et al. (2011) and Dick-Nielsen et al. (2012).

Notably, both market-driven liquidity as well as the corporate bond’s individual liquidity have a significant impact on the bond yield spreads and therefore actual returns.

When considering how such liquidity/liquidity risk affects the pricing of a corporate bond, studies to date have tended to focus on either total liquidity levels or common factors that affect liquidity. However, a bond’s liquidity may very well behave idiosyncratically in accordance with its issuer’s specific situation in the larger context of security behaviors within the corporate bond market. An example of this: most corporate bond market investments to date are made by a relatively small percentage of investment institutions, while the general populace of remaining investors knows little of how the market works. As noted by Heck et al. (2015), this results in a number of bonds on the market that exhibit higher liquidity simply due to the fact investors don’t know about them or don’t have access to them. (See also: The Dynamics of Liquidity and Investing.)

Substantial evidence indicates that a strong connection exists between systematic liquidity risk (also referred to as common liquidity risk) and the pricing of securities in the corporate bond market. Evidence also indicates that illiquidity affects yield spreads of corporate bonds. This affect is even more pronounced for high-yield bonds (also known as junk bonds). This susceptibility of yield spread is not significant in normal conditions, but it increases when the market enters a crisis across the board for all categories of bonds except for AAA. Friewald et al. (2012) find that liquidity accounts for up to 14% of a corporate bond’s yield -- a percentage that jumps to nearly 30% during times of financial stress such as a recession.

The liquidity of corporate bonds exhibits a shared or common component in that it varies over time. This variance is especially pronounced during recessions. The way a corporate bond responds to the shocks of illiquidity depends on its credit rating. While AAA bonds respond in a significant and positive way, higher-yielding corporate bonds respond in a negative fashion.

The evidence also suggests that the liquidity that plays the most significant role (common or idiosyncratic) shifts depending on the condition of the market. While the market is stable, the determining liquidity factors tend to be idiosyncratic, while the opposite is true when conditions worsen. This does not mean, however, that some corporate bonds may possess strong enough idiosyncratic liquidity features to protect them against or minimize the impact of such negative turns in the market.

Heck et al. (2015) found a significant relationship exists between yield spreads and bond illiquidity, both common and specific. The indication here is that the idiosyncratic behavior exhibited by the liquidity of some corporate bonds may be simply due to the closed nature of the market, that is, because the bond is not available to or known by all investors. In the corporate bond universe, a significant high amount of securities are merely available to institutional investors. Private/retail investors often can simply not invest in specific securities due to the lack of investment funds, since the bonds’ denominations are too high. In particular when an investor intends to construct a broadly diversified portfolio with corporate bonds that require a minimum denomination of 100,000 USD or higher, it becomes very obvious that sufficient funds must be available in order to achieve a high level of diversification.      

When comparing different types of corporate bonds, or bond groups, Heck et al. (2015) also found that both shorter-term and higher-yielding bonds experience greater susceptibility to such idiosyncratic illiquidity. (See also: High-Yield Bonds: The Pros and Cons.)

Several studies have demonstrated that illiquidity is priced in corporate bond yields. Hence, liquidity certainly matters in the corporate bond market and should be closely monitored by any investor, private or institutional. Clearly, investors need to pay attention to both, common liquidity in the market as well as bond-specific liquidity. Liquidity risk is a highly complex subject matter and always requires in-depth professional analysis and constant monitoring.