- Even though transaction costs tripled during COVID-19, both bid-ask spreads and total transaction costs remained significantly lower than during the 2008 global financial crisis, for investment-grade and high-yield bonds.
- One potential explanation for this is the increasing role of credit ETFs in providing liquidity through improved price discovery and greater trading activity during the more recent crisis period.
- The Federal Reserve’s intervention in the corporate- bond market may have also helped liquidity — not only for investment-grade bonds, but for the high-yield bond market.
Was the liquidity crisis during the COVID-19 outbreak worse than that experienced during the 2008 global financial crisis (GFC)? We compared transaction costs from the forced selling of USD 10 million of U.S. corporate bonds throughout the two crises. We found that even though transaction costs more than tripled during COVID-19, they remained significantly lower than during the GFC. The recovery of liquidity after the crisis peak also appears to have been faster for COVID-19.
Post-GFC Liquidity Concerns Overstated?
In the wake of the GFC, investors expressed concern that higher capital requirements and new regulations could reduce fixed-income liquidity.1 The potential consequence was that broker-dealers would be less likely to hold riskier instruments on their books and that dealer inventories and quoted trade sizes would decrease.2 In fact, corporate- and foreign-bond holdings of brokers and dealers have decreased from USD 363 billion in the first quarter of 2008 to USD 56 billion in the first quarter of 2020, according to data from the Federal Reserve. This trend could result in increasing the cost of executing larger trades, especially during periods of market distress.
But did the recent market turmoil during the COVID-19 crisis bear this out? Using MSCI’s liquidity model, the exhibits below show transaction costs from selling USD 10 million of U.S. investment-grade and high-yield corporate bonds.3 Transaction costs are further broken down into one-half of the bid-ask spread and market impact (a measure of the cost for large trades above the typical quote size). We find that total transaction costs remained strikingly lower during the COVID-19 crisis than during the GFC.
But what can explain the lower transaction costs? Two potential factors include the increased role of ETFs and the Federal Reserve’s intervention in the corporate-bond market.
Transaction Costs for Bonds During COVID Crisis Were Much Lower Than During the GFC
Market impact is the extra transaction cost above the half bid-ask due to the size of the trade above the typical quote size.
ETFs May Have Helped Provide Liquidity
One explanation for better liquidity may be the increased role of ETF trading in fixed-income markets. Trading volume in bond ETFs surged in the 12 years following the GFC,4 and the trading volumes of the largest corporate-bond ETFs tripled during the COVID-19 crisis period compared to the pre-pandemic 2020 period, according to our calculations.5 The trading of ETFs on exchanges may have improved price discovery during the COVID-19 crisis, when price uncertainty of bonds traded in the over-the-counter market was quite elevated.
As an example of ETF trading activity during the COVID-19 crisis, the exhibit below shows the trading volume and creations/redemptions of the iShares iBoxx USD Investment Grade Corporate Bond ETF during the COVID-19 crisis.6
ETF Trading Volumes Surged at the Peak of the COVID Crisis
Data on the iShares iBoxx $ Investment Grade Corporate Bond ETF.
Fed Interventions Also Helped
On March 23, 2020, the Federal Reserve announced the launch of its corporate-bond facilities, which initially covered investment-grade bonds only. These facilities were later extended to include ETFs (both investment-grade and high-yield) and bonds that had been downgraded to BB from BBB. Following the announcement, liquidity conditions significantly improved: Bid-ask spreads decreased (as shown in the first exhibit); the dispersion of quoted prices dropped rapidly; and dealers resumed quoting instruments for which they had stopped bidding during the peak of the crisis (exhibit below).
Market-Making Activities Dropped, Then Rebounded, During COVID
Better Liquidity Overall?
In conclusion, using MSCI measures of market impact and bid-ask, we can see that the liquidity crunch during the COVID-19 crisis was not as severe as during the GFC. While we cannot predict the effects of future crises, concerns about corporate-bond liquidity expressed over the past few years may have been overstated.
1 Osterland, A. “Investors worry liquidity crisis looms on fixed-income horizon.” CNBC, Dec. 3, 2018.
2 Levine, M. “Bond Investors Are Worried About Bond Market Liquidity.” Bloomberg, Dec. 3, 2017.
3 Knipl, D., Bohak, A., and Hollo, L. 2019. “Integrating Trade and Quote Market Data into Fixed Income Liquidity Research.” MSCI Model Insight.
4 Dieterich, C. “Bond ETFs are feeling the flow.” ETF Strategy, Aug. 2, 2019.
5 We looked at the volumes of the iShares iBoxx $ Investment Grade Corporate Bond ETF, iShares iBoxx $ High Yield Corporate Bond ETF, SPDR Bloomberg Barclays High Yield Bond ETF, Vanguard Intermediate-Term Corporate Bond ETF and Vanguard Short-Term Corporate Bond ETF.
6 The iShares iBoxx $ Investment Grade Corporate Bond ETF was chosen as it had one of the largest trading volumes during the COVID-19 crisis. The trends in traded volume were similar for other large corporate-bond ETFs.