<i>CFA Institute Journal Review</i> summarizes "Providing Liquidity in an Illiquid Market: Dealer Behavior in US Corporate Bonds," by Michael A. Goldstein and Edith S. Hotchkiss, from the <i>Journal of Financial Economics</i>, January 2020.
Investigating market-making activities for infrequently traded US corporate bonds reveals dealers are inclined to quickly find a buyer for the least actively traded bonds to avoid holding them in inventory. In many cases, dealer spreads on the most illiquid bonds are lower than those on the more liquid bonds, contrary to prior research.
What Is the Investment Issue?
Despite their substantial number and dollar value, many US corporate bonds trade infrequently, if at all. Not much is clear about market makers’ challenges in providing liquidity to the over-the-counter (OTC) bond market. Dealers may not wish to purchase illiquid bonds from investors because they could languish in inventory, and the costs of finding a counterparty to offset the trade could be substantial.
A growing body of research on OTC dealer markets forms the basis for the authors’ inquiry. Understanding this market’s trading behavior is multidisciplinary and brings together concepts of inventory management, network formation, and search models. The liquidity metrics employed in equity markets that gauge trade immediacy (liquidity) in nanoseconds do not hold for bonds, for which immediacy often means hours, if not days. Unlike prior research, the authors focus on less actively traded bonds, which helps broaden our understanding of bond market liquidity.
How Did the Authors Conduct This Research?
The authors gather corporate bond data from the Financial Industry Regulatory Authority as reported to the Trade Reporting and Compliance Engine for the period July 2002 to March 2011. The 55,988 bonds have an average maturity of slightly more than five years, a median investment-grade rating of A, and at least one dealer roundtrip. A roundtrip is when a dealer buys and then sells the same bond. Roundtrips can be paired (the same quantity that is bought is sold in the same day via one sale), unpaired (the same quantity bought is sold in the same day via more than one sale), or completed in more than one day (requiring the dealer to inventory the bonds for a median of 21 days).
The authors hypothesize that investors experience higher trading costs, or even illiquid markets, when dealers’ search and inventory costs are high. Anticipated high inventory costs will lead dealers to prearrange trades, especially for more illiquid and lower quality bonds. Investors retain the inventory risk as the dealer searches for a counterparty. When dealers prearrange roundtrips that transfer inventory risk, the investor may not incur higher observed trading costs.
The authors then study roundtrip trading costs and their interrelationship with dealer holding periods, considering whether dealers adjust holding periods to minimize inventory risk. These considerations inform the authors’ construction and testing of endogenous switching regression models involving holding periods, roundtrips, and spreads. Finally, the authors examine dealer behavior in stressed markets.
What Are the Findings and Implications for Investors and Investment Professionals?
By concentrating on corporate bonds with the least trading activity and therefore greater inventory risk, the authors reveal that dealers balance the costs of searching for a counterparty with the costs of inventory. These costs depend upon the bonds themselves and if they are in demand, the dealers and the structure of the dealer market, the other potential counterparties (investors), and the state of the capital markets.
The median bond trades 3.1 times per month. Bonds in the lowest trading decile have a trade count of 0.1 times per month, while those in the 5 highest trading deciles have a trade count of 12.3 times. The top 1% of the 55 dealers studied account for about two-thirds of trade. About 60% of same-day roundtrips are between dealers and investors, contrary to prior research.
Dealers’ trading behavior is a function of a bond’s anticipated liquidity. Dealers complete a higher percentage of same-day paired roundtrips for the least active bonds. Acting more as brokers and less as dealers when liquidity is lacking, dealers manage expenses of search and inventory to reduce their costs.
The overall median roundtrip spread, defined as the dealer sell price less the dealer buy price, is 15 basis points (bps). Contrary to prior studies, spreads on the least actively traded bonds rated A or better are lower than the spreads on the more actively traded bonds (10 bps versus 12.5).
Median spreads are 10 bps for same-day paired roundtrips, 23 bps for same-day unpaired roundtrips, and 29 bps for roundtrips completed in more than one day. Spreads for same-day roundtrips are highest when a dealer buys from another dealer and sells to an investor (up to 32 bps) and 6 bps if the dealer sells to another dealer.
Dealer behavior during the Great Recession of 2007–2009 confirms the propensity to minimize inventory risk. In stressed markets, investment-grade bonds may trade at steep discounts even if the dealer can find a counterparty.
The authors’ inquiry and findings appear to refute conventional thinking on market microstructure that posits dealers as passive order takers—prone to hold less frequently traded assets in inventory and susceptible to greater pricing risk, resulting in wider bid–ask spreads.