When liquidity is most needed in the high-grade corporate bond market, it “could get ugly,” Bank of America Merrill Lynch predicts. While total volume has increased meaningfully since 2006, don’t let that fool you. The markets are not liquid, the analysts say, pointing to the Volcker Rule and central bank quantitative easing that has put investors reaching for yield on a ledge.

High-Grade Corporate Bond Market Market – Don’t conflate volume with liquidity

High-grade corporate bond trading has nearly doubled in the decade following the global financial crisis, BofA’s Hans Mikkelsen and Yunyi Zhang observe. With annual volume at $4.1 trillion, don’t make the mistake of conflating volume with liquidity.

In a report titled “When the tide goes out,” Mikkelsen and Zhang consider trading volume as a share of market size and point to a declining picture.

Annual trading volumes in the high-grade corporate bond market were 135% of the size of the market back in 2006, but post-crisis they estimate that number is only 86% in 2017.

There are numerous methods to gauge market liquidity, with bid-ask spreads being one. The message this measure is sending is not as positive as market volume numbers might lead observers to believe.

“Counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels,” the report observed, pointing to bid/ask spreads even though they “are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds.”

High-grade corporate bond market data on bid ask spreads is not often tracked and when it is only in markets with strong liquidity and trade volume. “In contrast, liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders,” they observed. In fact, what Mikkelsen and Zhang think might play out a “back to the future” effect.