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Thin liquidity
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The sharpest one day fall in oil markets since the 1991 Gulf War on Monday revealed familiar cracks in the corporate credit market.
The 34% fall in benchmark crude oil prices in four days to the lowest level since February 2016 helped to produce sharp swings in prices for corporate bonds and expose old concerns about the lack of trading in a market that has seen the primary providers of liquidity pull back in the aftermath of the 2008 financial crisis.
Analysts have complained that post-crisis regulations have made banks and other broker-dealers less willing to warehouse risky corporate debt, making it more difficult to buy and sell such securities.
The oil plunge on Monday hit the energy sector particularly hard and it represents around 10% share of the overall U.S. sub-investment grade bond market, or junk bond market. The widening spread between corporate debt and U.S. Treasury yields helped to increase the cost of trading, with the bid-ask spread, or the difference between prices quoted between buyers and sellers, for corporate debt widening sharply on Monday.
“Bid-ask spreads are blowing out for the worst companies, especially in the energy space,” said Michael DePalma, managing director at MacKay Shields, who oversees the HYLD exchange-traded fund HYLD, +0.51%. “Credit’s just getting creamed.”
See: Bond investors say some energy companies ‘will not survive’ oil rout slamming markets
Falling prices for sub-investment grade corporate debt, or “junk” pushed their yields higher, increasing the premium investors paid to own such risky debt over equivalent Treasurys
This premium, or credit spread, surged to 668 percentage points at the end of Monday from a recent low of 3.49 percentage point on Jan.6, according to an index tracked by ICE Data Services. For investment-grade, this spread shot up to 2.05 percentage points from around 1.20 percentage points at the start of the year.
Monday also saw the biggest selloff in US. stocks since 2008. The S&P 500 SPX, +4.93% fell 7.6%, and the Dow Jones Industrial Average DJIA, +4.89% retreated 7.8%.
Yet unlike in equities, prices and yields in the corporate bond market do not necessarily reflect actual transactions at those values, given the hefty transaction costs associated with buying or selling a security.
Indeed, the tumble in corporate bond values dried up liquidity among dealers selling debt even for the highly rated bonds.
The bid-ask spread for bonds issued by businesses rated between A to BBB and sporting a maturity between one to five years, usually a highly liquid corner of the corporate debt universe, blew up to an average of 120 basis points on Monday, according to data from Bond Wave.
In other words, if an investor tried to sell $1 million worth of bonds, they would have to give up 1.2% of the overall bond’s value and receive $988,000 in cash.
During less frenzied trading periods, this spread was more frequently seen at a more muted 20 to 30 basis points. Even in the peak of the December 2018 selloff in U.S. equities, the bid-offer spread rose to less than 60 basis points.
Paul Daley, managing director of Bond Wave, said the hefty transaction costs recorded on Monday were a reflection of how much of the trading was driven by the most vulnerable bonds, such as those listed by energy companies, with debt sold by issuers in other industries seeing few transactions. He added it was hard to gauge bid-ask spreads in the junk bond market as few investors dared to sell their bonds.
Daley said it was likely that with few willing to snap up energy debt on Monday, broker-dealers were demanding a much lower price from other market participants to hedge the risk of keeping the bonds in inventory, at a time where a security could lose even further value, until the dealer could find a buyer.
“Yesterday, dealers were probably trying to offset that risk,” said Daley.
But unless mutual funds or other institutional investors face redemptions from their clients, most investors would keep their corporate debt holdings as long as possible in the hopes of outlasting the market turmoil.
“If you’re not forced to sell, most people won’t,” said DePalma.
