The International Organization for Securities Commissions has published a report studying the effect of stressed market conditions on liquidity in corporate bond markets. The report arose out of concerns about liquidity in the corporate bond market in the years since the global financial crisis and, in particular, the possibility that a significant sell-off could trigger price volatility and temporarily depress prices. The report is based upon a review of existing studies of corporate bond markets, an examination of historic periods of market stress and discussions with industry stakeholders.



The report's assessment of the existing status of corporate bond markets found some conflicting results, but broadly established that liquidity levels during non-crisis periods had not varied substantially from historical norms. Market participants did, however, note certain changes in the corporate bond markets arising from a combination of post-crisis regulatory reforms (including regulatory capital reform, the Volcker Rule on proprietary trading in the U.S. and the Vickers reforms on bank structure in the U.K.) and increased risk aversion. Broker-dealers have, according to market participants, reduced their inventories of corporate bonds, concentrated holdings in higher-grade and more liquid corporate bonds and increased their agency trades (executed on behalf of customers) relative to their principal trades. Although the findings are not conclusive, there are indications that broker-dealers are less willing to provide liquidity in corporate bond markets.



Looking to the future, the report considers how market participants may now behave under stressed market conditions. Key observations include: (i) an anticipation of larger than usual price volatility in periods of market stress; (ii) a decreased likelihood of forced selling among banks due to improved bank capitalization and reduced leverage in the market; and (iii) an expectation that institutional investors will be able to provide demand-side support during periods of market stress. Distressed-debt investors, hedge funds and private equity funds are likely to be the market liquidity providers of last resort, although the capacity of those market participants is questioned in the report due to post-crisis regulations and risk aversion. The report concludes with the observation that two critical variables in determining the liquidity of corporate bonds under future stressed conditions are likely to be: (i) the quality of liquidity risk management of market participants that will be used to meet redemptions during periods of market stress; and (ii) the ability of asset managers and investment funds to take advantage of asset mis-pricing.



View the report.

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