Is it time to worry about credit market liquidity ?

Yes, probably according to BofAML analysts.

« Our analysis shows fewer bonds trade on a daily basis over the past year. We also find that trading volumes are declining over the past years as a percentage of the stock of corporate bonds. Liquidity is concentrated in benchmark bonds; 5y and 10y bonds exhibit better liquidity both in terms of tighter bid/offer spreads and also higher turnover. Higher spread/yield bonds exhibit better liquidity. »

The fact that liquidity has significantly decreased in credit market is worrisome. Yet there is also good news. While liquidity has declined in cash bond markets, it has also improved in the CDS market – a point that several fixed income managers have confirmed over the last couple of months.

According to Merrill Lynch:

« While liquidity is becoming more challenging in the corporate bond market, it has improved in the credit derivatives market, over the past years. Notably, credit CDS indices and credit index options have been the products of choice to express views in fast-moving markets. »

Further in their report, Merrill’s analysts write:

« Away from the cash market, synthetics have been another form of gaining exposure to trade credit risk. Within the synthetics market CDS indices have been outperforming single-name CDS over the past semester. The index-to-intrinsics skew at one point reached 13bp for iTraxx Main (index trading inside singles), when the index was trading at ~70bp. This clearly reflects the preference of credit investors for liquid and scalable instruments to position for tighter spreads.

Credit investors (that have the ability to use CDS in their portfolios) prefer to manage part of their portfolio risk via CDS indices. This is predominately due to better liquidity (vs single-names CDS and bonds) that is reflected in tighter bid/offer spreads. »


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