Does liquidity spill over in the credit market? The case of CDS and corporate bonds

Robert Czech

Credit default swaps (CDS) have a notoriously bad reputation. Critics refer to CDS as a “global joke” that should be “outlawed”, not at least due to the opaque market structure. Even the Vatican labelled CDS trading as “extremely immoral”. But could there be a brighter side to these swaps? In theory, CDS contracts can reduce risks in financial markets by providing valuable insurance. In a recent paper, I show that CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.

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What happens when ‘angels fall’?

Yuliya Baranova, Harry Goodacre and Jamie Semark.

Over the past 20 years, the share of outstanding corporate bonds rated BBB, the lowest investment-grade rating, has more than doubled. This has left a large volume of securities on the edge of a cliff, from which they could drop to a high-yield rating and become so-called ‘fallen angels’. Some investors may be forced to sell ‘fallen angels’, for example if their mandate prevents them from holding high-yield bonds. And this selling pressure could push bond prices down, beyond levels consistent with the downgrade news. In this post we explore the impact that sales of ‘fallen angels’ could have on market functioning, finding that they could test the liquidity of the sterling high-yield corporate bond market.

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Bitesize: Trading activity during the Corporate Bond Purchase Scheme

David Mallaburn, Matt Roberts-Sklar and Laura Silvestri.

The Bank of England’s August 2016 monetary policy package included the £10bn ‘Corporate Bond Purchase Scheme’ (CBPS). But who did the BoE buy those bonds from?

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What did the CBPS do to corporate bond yields?

Calebe de Roure, Ben Morley and Lena Boneva

In August 2016 the MPC announced a package of easing measures, including the Corporate Bond Purchase Scheme (CBPS). In a recent staff working paper, we explore the announcement impact of the CBPS, using the so called “difference in differences” (or “DID”) approach. Overall – to deliver the punchline to eager readers – this analytical technique suggests that the announcement caused spreads on CBPS eligible bonds to tighten by 13bps, compared with comparable euro or dollar denominated bonds (Charts 1b, 2). Continue reading “What did the CBPS do to corporate bond yields?”

Forming strong bonds: dynamics in corporate bond markets

Karen Braun-Munzinger, Zijun Liu and Arthur Turrell.

If a boat is unstable and someone jumps out, does it capsize the boat for everyone else? In a novel application of agent-based modelling, we examine how investors redeeming the corporate bonds held for them by open-ended mutual funds can cause feedback loops in which bond prices fall further, posing risks to financial stability. In our model, reducing the speed with which investors pull out their investments over time helps to keep prices stable and remaining investors’ savings on an even keel.

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What explains the fall in sterling corporate bond issuance?

David Elliott and Menno Middeldorp.

Sterling could be falling out of favour when companies choose which currency to borrow when issuing bonds. Annual gross sterling issuance has almost halved since 2012, and sterling’s share of global issuance in 2015 was the lowest on record. According to those active in the sterling corporate bond market, some of the reasons for this decline are structural. These include changes in the investor base, annuities reform, and competition from the euro corporate bond market. These changes to the demand for sterling corporate bonds imply higher costs of bond issuance. Firms with limited access to foreign currency bond markets, such as small UK-focussed firms, or those with a lower credit rating, may face higher borrowing costs as a result.

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Has corporate bond market liquidity fallen?

Yuliya Baranova, Louisa Chen and Nicholas Vause.

Many investors report recent declines in market liquidity, suggesting dealers have become less willing to trade corporate bonds and other fixed-income securities due to additional costs of holding them on their balance sheets. Some fear that if asset managers began to sell these securities then prices could fall sharply. Focusing on high-yield corporate bonds, we use an econometric model to investigate whether the typical responses of dealer inventories and market prices to falls in asset manager demand have changed in recent years. We find that dealer holdings act less as a shock absorber than they did around a decade ago. Instead, bond spreads rise more. We also find that greater declines in issuance now follow these shocks.

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