High Yield – Liquidity Crisis

Liquidity is starting to dry up across segments of the corporate bond markets. The ominous widening of spreads in the high-yield bond market — from 322 basis points on Oct. 2 to 422 points on Nov. 20 — could be a sign of trouble to come.

The situation could be particularly acute for BBB-rated bonds, the lowest-rated bonds on the investment-grade spectrum. They now account for nearly half of the $5.8 trillion investment-grade market.

So-called fallen angels — investment grade credits that become junk-rated — are particularly vulnerable to liquidity crunches because many institutional investors are not allowed to invest in junk bonds. The selling that typically follows a downgrade to junk status can be massive and rapid.

The cause to the liquidity dry up in the High Yield Bond is also due to the role that Banks used to play in the past.

The big change in the bond markets since the financial crisis is the diminished role of the banks and investment dealers as investors and market makers. Prior to the crisis, banks and brokers kept large inventories of corporate bonds and issued quotes to buy and sell them with customers in the market.

For better and for worse, the regulatory reforms adopted post-crisis changed the system dramatically. Stricter capital reserve requirements by the Fed and rules against proprietary trading by regulated banks (aka, the Volcker rule) both reduced the willingness of banks and bond dealers to finance inventories and changed their role in the marketplace from principal to agent.

Reference

CNBC, Andrew Osterland, 2018-12-03, “Investors Worry Liquidity Crisis Looms on Fixed-Income Horizon”