Why Does Liquidity Matter in the Corporate Bond Market?

The liquidity of a corporate bond plays a crucial role in its ability to carry out large-scale, low-cost asset trades without causing significant price changes. Studies have found a strong connection between systematic liquidity risk and securities pricing in the corporate bond market. Research suggests that during market volatility, illiquidity can substantially impact yield spreads, which tend to widen significantly. Bonds rated AAA are more capable of withstanding periods of financial stress than other bonds. Institutional investors make most corporate bond investments, as retail investors often lack access to these opportunities or the necessary capital.

Basics

The liquidity of a corporate bond fundamentally shapes its capacity to facilitate substantial, cost-effective asset transactions without causing significant price fluctuations. Extensive research, as seen in studies like "Market Liquidity and Trading Activity" and "The Illiquidity of Corporate Bonds," underscores the profound correlation between a bond's liquidity and its yield spread.

Exploring Common (Systematic) Liquidity in the Market

Empirical findings highlight a robust link between systematic liquidity risk, often termed common liquidity risk, and the valuation of securities within the corporate bond market. These findings further reveal that illiquidity significantly impacts yield spreads, particularly widening during periods of market turbulence.

A research study by Friewald et al. in 2012 uncovered that liquidity contributes to approximately 14% of a corporate bond's yield in calm market conditions. Remarkably, this proportion escalates to nearly 30% during economic downturns and other financial stress periods. It's noteworthy that this trend applies to all bonds, with the exception of those rated AAA.

Overall, corporate bond liquidity exhibits variation, particularly in uncertain economic climates. However, the response to illiquidity shocks varies among corporate bond classes, with a significant reliance on credit ratings. AAA-rated bonds demonstrate favorable responses, while lower-rated, higher-yielding corporate bonds face adverse outcomes. In stable markets, liquidity determinants primarily stem from idiosyncratic factors shaped by the unique behaviors of each issuer.

The Bond’s Specific (Idiosyncratic) Liquidity Explained

Corporate bond liquidity exhibits varying trends, especially in economic uncertainty. Response to liquidity shocks diverges among corporate bond classes, which rely heavily on credit ratings. AAA-rated bonds show resilience while higher-yielding, lower-rated corporate bonds face challenges. In stable markets, liquidity determinants become idiosyncratic, shaped by each issuer's behaviors.

In research conducted by Heck et al., a substantial connection was revealed between yield spreads and the illiquidity of bonds. Their study pinpointed that the idiosyncratic liquidity behavior of certain corporate bonds can be attributed to the restricted nature of the market. Investors might refrain from investing in these bonds due to a lack of awareness about their existence or restrictions preventing access.

Challenges for Individual Investors in High-Denomination Bonds

Individual retail investors often confront constraints when considering investments in corporate bonds bearing substantial denominations, typically exceeding $100,000. These substantial figures hinder their ability to integrate these corporate bonds into their diversified portfolios effectively. Comparing various corporate bonds, Heck's research unveiled that both shorter-term and higher-yielding bonds are more susceptible to idiosyncratic illiquidity.

Conclusion

A multitude of research has indicated that corporate bond yields incorporate pricing related to illiquidity. Consequently, liquidity wields a substantial impact on the corporate bond market and warrants vigilant scrutiny from individual and institutional investors. Liquidity risk is a profoundly intricate topic, necessitating comprehensive professional evaluation.