Post-crisis regulations and corporate bond markets

Many believe liquidity — the ease and cost-efficiency with which investors can buy or sell bonds — isn’t what it was before the recession. Hank Bessembinder, professor of finance at the W. P. Carey School of Business, and colleagues from Southern Methodist University went beyond anecdotes and assessed whether dealers have become less committed in recent years to making markets in corporate bonds.

Investors remember the harrowing decline of stock markets during the Great Recession, the shutdown of once-famous financial institutions like Lehman Brothers Holdings Inc., and governments’ efforts to prevent more financial meltdowns. Some investors, however, don’t realize the toll such efforts took on the nation’s supposedly stable corporate bond markets. Many observers think those bond markets haven’t yet recovered. They say liquidity — the ease and cost-efficiency with which investors can buy or sell bonds — isn’t what it was before the recession. Hank Bessembinder, professor of finance at the W. P. Carey School of Business, and colleagues from Southern Methodist University wanted to go beyond anecdotes and assess the comprehensive evidence as to whether dealers have become less committed in recent years to making markets in corporate bonds.

In new research on capital commitment and illiquidity in corporate bonds, they sought to identify measures of dealers’ commitment to bond market making and to understand if and when those measures declined. “The financial crisis affected the bond markets in a way that was parallel to what happened in the stock markets. Prices dropped, and it became hard to trade and expensive to trade. The key difference is the stock market has come back,” Bessembinder said. As for bond markets, “prices recovered, but there are still concerns regarding what people have to pay to get the trades done and how difficult it is to get trades done.” Liquidity is important to bond markets because corporations issue bonds to raise capital for long-term investments. Investors, though, might not want to hold the bonds for the long term. Liquid markets help investors sell corporate bonds easily and without big price concessions, Bessembinder said, while illiquid markets make investments harder to trade and make people less likely to invest.

What might have hurt liquidity

Some observers who perceived a problem in the bond markets blame it on the “TRACE” — the Trade Reporting and Compliance Engine — the establishment of which was required by the U.S. Securities and Exchange Commission. TRACE makes bond trading more transparent by requiring dealers to report trade prices to a public database where they can be seen by all potential buyers and sellers. Critics say the system has cut into dealers’ profitability and driven liquidity providers out of the market. Others blame any problems in the corporate bond markets on capital and trading regulations imposed on banks in the wake of the Great Recession.

Specifically, they point to the Volcker Rule, named for former Federal Reserve chairman Paul Volcker, which restricts banks trading in speculative investments and limits banks’ ownership of hedge funds. The rule is part of the Dodd-Frank Wall Street and Consumer Protection Act, which became law in 2010. They also point to an international regulatory framework known as the Basel III accords. The multinational Basel Committee on Banking Supervision designed the regulations to reduce banks’ allowed leverage and tighten requirements for their capital holdings. Those regulations began phasing in 2014. Bessembinder’s team wanted to go beyond perceptions and anecdotes to document the facts regarding transaction costs and liquidity, and the possible effects of the TRACE system and the implementation of new bank regulations.

Data show what really mattered

To document any changes from 2003, before the financial crisis began, to 2014, when the new regulations took effect, the team used the TRACE database of transactions in U.S. corporate bonds during that period. In addition to standard TRACE data, the Financial Industry Regulatory Authority Inc. provided masked dealers’ identities that allowed the researchers to track the trades of individual dealers over time. The researchers examined a sample of nearly 62 million transactions covering more than 40,000 securities. They sorted the transactions into periods, starting with those made during the TRACE phase-in period from 2003 to 2005. For a benchmark, they used transactions made in the post-TRACE but pre-crisis period of 2006 and the first half of 2007. Transactions in the crisis period ran from July 2007 to April 2009, in the post-crisis period from May 2009 to June 2012 and in the regulatory period from July 2012 to May 2014. Perhaps surprisingly in light of recent concerns, the team documented that transaction costs in bond markets have actually declined in recent years.

Average costs did spike during the financial crisis, but the research showed they have trended down overall, from an average of 0.61 percent in 2003-2004 to 0.42 percent in 2014. “What investors pay when corporate bond trades are done is as low as it’s ever been,” Bessembinder said. However, since transaction costs are based on completed trades, the team reasoned, they don’t factor in the difficulty investors might have in completing trades or the cost of trades that investors want to make but do not complete. They also noted that trading activity in corporate bonds has actually decreased in recent years relative to the quantity of bonds outstanding.

They next turned to various measures of capital commitment to shed more light on the problem. “We are trying to assess the extent to which, if you want to do a trade in the bond market, are the dealers ready to step up and take the other side of that trade,” Bessembinder said. Their findings showed that several measures of dealer capital-commitment fell during the financial crisis, and many even got worse during the post-crisis and regulatory periods. The researchers assessed in particular how long bond dealers were willing to hold the bonds they bought. The frequency with which dealers held bonds overnight in their inventory declined sharply from the pre-crisis period to the most recent regulatory period, indicating that bond dealers are less willing to absorb customer trades on a long term basis. Another significant finding was that dealers now do fewer large block trades, with the share of block trades falling from 27 percent pre-crisis to 22 percent in the regulatory period. The finding is relevant, Bessembinder said, because the bond market is mostly comprised of large institutions such as mutual funds, pension funds and insurance, who now would find it more difficult to make the large trades that they naturally desire.

The team also assessed the possibility that the decline in capital commitment was due to the unintended consequences of banking regulations such as the Volcker Rule and Basel III. Most corporate-bond dealers had been affiliated with banks, and even before the Volcker Rule took effect in 2014, some large banks, including Goldman Sachs and Bank of America, closed their proprietary trading desks. “The rule was not intended to affect market-making activity,” Bessembinder said. “But as a practical matter, it can be hard to find the exact dividing line between speculation and market-making. To assess this issue, the researchers also looked at how banks’ activity during the period differed from that of non-bank dealers. The data clearly showed that the drop in dealers’ capital commitment to the bond market was entirely due to a decline in bank-affiliated dealers’ activity.

In contrast, non-bank dealers increased their commitments. The evidence is circumstantial but strong, Bessembinder said, and is consistent with the idea that the changes in banking regulations contributed to illiquidity in corporate bond markets. TRACE, they found, also had little impact on bond-market liquidity. For both public and private bonds, measures of dealers’ capital commitment to bond market making varied little from before the reporting system’s phase-in to after its phase-in. Privately traded bonds, which were not yet subject to TRACE reporting, actually suffered more during the financial crisis than did the transparent, public bonds. To the extent there is a problem with liquidity in the bond markets, the researchers say, TRACE does not appear to be the cause. “Overall, it is important to know that the sky has not fallen. The fact that transaction costs are actually down, not up, is an important part of this discussion,” he said. “On the other hand, it’s probably a more difficult market than it used to be, and that does leave one nervous about what might happen in any future period of instability if dealers are less willing to commit capital.”

Bottom line

Bessembinder said the research has these lessons for bond-market stakeholders:

• For individual investors: Be aware of the potential for less liquidity in the bond markets should financial markets encounter turmoil. That could mean riding it out or making contingency plans.
• For corporations issuing bonds: Be aware that decreased liquidity in the secondary market could make it more difficult to make new bond issues, and plan any offerings accordingly.
• For bond market professionals: The research verifies what many of those in the trenches are seeing every day. Banks are turning from their traditional role of making markets as dealers who commit capital overnight or longer, toward a new role of acting as agents who match bond buyers and sellers. The landscape is changing as new, non-bank dealers enter the market and step up their capital commitments.
• For lawmakers and regulators: The research illustrates how regulations can have unintended