July 15, 2021

Dealer Inventory Constraints in the Corporate Bond Market during the COVID Crisis

Craig A. Chikis and Jonathan Goldberg1

Overview and Main Results

Beginning in late February 2020, market liquidity for corporate bonds dried up and corporate bond credit spreads soared amid broad financial market dislocations related to the COVID-19 pandemic. The causes of this liquidity dry-up and the spike in corporate bond spreads remain subjects of debate. One question is whether the liquidity dry-up was driven by reduced liquidity supply by dealers, increased liquidity demand by investors, or both. Dealers have a central role in the corporate bond market and use their balance sheets to provide liquidity to corporate bond investors. Thus, one potential explanation of the liquidity dry-up is a reduction in dealers' balance-sheet capacity, or liquidity supply. Another potential explanation of the liquidity dry-up is a rise in liquidity demand, for example, due to investor redemptions at corporate-bond mutual funds.2 Whether liquidity supply or liquidity demand was a key driver of the liquidity dry-up is important for understanding the COVID crisis and how Federal Reserve policy actions affected investor welfare and dealer profits. There is also debate regarding the effectiveness of Federal Reserve policy actions during the COVID crisis and whether these actions affected dealers' liquidity supply.3

To address these questions, we study the price and quantity of liquidity in the corporate bond market and use these measures to disentangle shifts in liquidity supply and demand. Our measures of the price and quantity of liquidity were developed in Goldberg and Nozawa (2021), which studied the data from 2002 to 2016.

Our main results are the following:

• The price of liquidity declined notably after the March 23 announcement of the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) and the April 9 announcement expanding the size and scope of the corporate credit facilities (CCFs).
• The evolution of the liquidity price for bonds with differing eligibilities for the CCFs provides suggestive evidence that the CCF announcements were important causal drivers of the improvement in market liquidity in late March and April.4
• We parse the evolution of liquidity supply and demand using Goldberg and Nozawa's (2021) model. The model attributes the liquidity dry-up during the COVID crisis about equally to lower liquidity supply and higher liquidity demand. Our liquidity supply index reached a trough on March 20, after the Primary Dealer Credit Facility (PDCF) announcement.
• Our analysis suggests that roughly one-fourth of the decline in the value of corporate bonds between February 28 and March 20 was due to reduced dealer balance sheet capacity. Between February 28 and March 20, corporate bonds fell in value with a return of negative 13.5 percent, as measured by the ICE Bank of America U.S. Corporate Total Return Index. Applying the estimates in Goldberg and Nozawa (2021), the decline in dealers' balance sheet capacity between February 28 and March 20 increased the expected one-year-ahead excess return on corporate bonds by 3.4 percentage points.5 In contrast, increases in liquidity demand have historically been associated with quantitatively small increases in expected excess returns.
• The evolution of the price and quantity of market liquidity differed markedly from the 2007–09 crisis. The liquidity price peak was 90 basis points during the 2007–09 crisis and about double the peak in the COVID crisis. The rise in the liquidity price was also much more persistent. Strikingly, the quantity of liquidity provided by dealers plunged during the 2007–09 crisis, whereas it fell much more modestly during the COVID crisis. Correspondingly, our supply-and-demand model attributes the liquidity dry-up during the 2007–09 financial crisis primarily to fluctuations in liquidity supply, whereas the COVID liquidity dry-up is attributed roughly equally to liquidity supply and demand.

Price and Quantity of Market Liquidity

In many asset classes, dealers use their balance sheets to make markets and provide immediacy to investors. When dealers' inventory capacity is strained, assets in dealer-intermediated markets can trade at prices away from their fundamental values. In theories of liquidity with inventory frictions, temporary price deviations—or noise in prices—reflect the expected return for providing liquidity.6 A well-known measure of such price deviations is Treasury noise—deviations of individual Treasury yields from a smooth fitted yield curve. Goldberg and Nozawa (2021) measures noise instead in the corporate bond market.7 Each day, we fit a smooth yield curve using bond-level yields for each large issuer of corporate bonds. Specifically, we fit a Svensson (1994) yield curve to the individual yields on each issuer's bonds. We limit the sample to dollar-denominated publicly offered bonds with fixed coupons and no embedded options other than make-whole call provisions and issuers with at least seven issues outstanding.8

Our noise measure is the average, across all bonds in our sample, of the divergence between a bond's market yield and the yield curve of its issuer. A key advantage of our noise measure is that all issuer-specific information is absorbed by the fitted yield curve and thus the measure is not affected by asymmetric information about issuers. We use this noise measure as our liquidity price.

We begin our discussion of the results by describing the evolution of the noise measure, with a particular focus on the COVID crisis. The top panel of Figure 1 provides a historical perspective covering January 1997 to June 2020. The bottom panel shows the evolution of aggregate noise in the corporate bond market during the first half of 2020, which includes the COVID crisis in financial markets. Historically, the average level of noise is 14 basis points.9 At the start of 2020, corporate bond noise was about 11 basis points. Noise rose only a bit in late February and early March amid steep declines in equity markets. However, noise spiked beginning in mid-March, amid signs of large corporate bond sales by investors (Haddad, Moreira, and Muir (forthcoming)). On March 17, the Federal Reserve announced that it would establish a Primary Dealer Credit Facility (PDCF) to address dealers' funding needs. The PDCF would offer loans to primary dealers with a term of up to 90 days, collateralized by a broad range of investment-grade (IG) debt securities. However, noise increased significantly even after the announcement of the PDCF. The PDCF began operations on March 20. Noise reached a peak of 50 basis points on March 23.

On March 23, the Federal Reserve announced the establishment of the CCFs. The PMCCF would purchase new debt from issuing corporations and the SMCCF would purchase corporate debt from investors in the secondary market. After the CCFs were announced, noise declined quickly, reaching 25 basis points in early April. After the announcement on April 9 that CCF eligibility would include some high-yield (HY) bonds, noise declined further, reaching 17 basis points in early May. There was little change in noise around the start of SMCCF purchases. Since then, noise has declined slightly, on balance, averaging 14 basis points in January 2021.

Figure 1: Noise in the corporate bond market

Next, we compare the evolution of noise during the COVID crisis and during previous episodes of fixed income market stress. The spike in noise during the COVID crisis was

• significantly smaller and less persistent than the spike in noise during the 2007–09 financial crisis. During the 2007–09 crisis, noise approached 20 basis points in September 2008, peaked at 90 basis points in December 2008, and only returned to its May 2007 level in January 2018, one decade later.
• somewhat smaller than the spike in noise during the 1998 Long-Term Capital Management crisis but slightly larger than the spike following the WorldCom default in 2002, which had a large effect on fixed income markets.

Figure 2, top panel, shows the evolution of noise during the COVID crisis for IG bonds and, separately, for HY bonds. Noise for IG bonds peaked on March 20—after the PDCF announcement, on the same day as the PDCF entered operation, and before the original CCF announcement on March 23. IG noise then declined rapidly. In contrast, HY noise continued to rise after the March 23 announcement, peaking on April 9, the day of the announcement describing the extension of the SMCCF to include some HY bonds, after which HY noise declined notably. While many factors might have differentially affected IG and HY liquidity over this period, these different time patterns of IG and HY noise point to the CCF announcement as a key explanation for the improvement in market liquidity in late March and in April.10

Figure 2: Noise, by credit rating and remaining time to maturity

To provide further evidence regarding the effects of the CCFs, Figure 2, bottom panel, shows the evolution of noise for bonds with less than five years remaining maturity and bonds with more than five years remaining maturity. Eligibility for the SMCCF was restricted to bonds with less than five years remaining maturity.11 Notably, noise for sooner-maturing bonds (bonds with less than five years remaining maturity) initially increased much more rapidly than noise for bonds with longer maturities. However, after the first CCF announcement, noise declined much more rapidly for bonds with lower maturity. Noise for such bonds also declined more over the weeks following the second CCF announcement. These results provide further evidence pointing to the CCF announcements as contributing to improved liquidity during the COVID crisis. Nonetheless, this pattern could also be consistent with, for example, other news or announcements differentially affecting sooner-maturing and later-maturing bonds. Indeed, at times of stress such as the 2007–09 financial crisis, the spike and then recovery of noise was sharper for shorter-maturity bonds than for longer-maturity bonds. Figure 3 shows the liquidity price for securities with less than five years remaining maturity, and for securities with more than five years remaining maturity, during the COVID crisis (left panel) and the Global Financial Crisis (right panel). The liquidity price in Figure 3 is z-score standardized to facilitate comparisons across and within each panel.

Figure 3: Noise, by remaining time to maturity: Comparing the Global Financial Crisis and COVID crises

We complement this analysis of the price of liquidity by examining the quantity of liquidity primary dealers provided using their balance sheets. To absorb the demand imbalances that give rise to noise, dealers take long positions in bonds that investors want to sell and short positions in bonds investors want to buy. Thus, we measure the quantity of liquidity as the sum of dealers' gross long and gross short positions. We calculate this quantity using transaction data from the Trade Reporting and Compliance Engine (TRACE). The procedure to convert transaction data into dealer positions is based on cumulating weekly flows to estimate each dealer's net position in each bond, as described in detail in Goldberg and Nozawa (2021). Our quantity measure is the sum of the absolute value of primary dealer positions in each bond.

Figure 6: Evolution of liquidity supply and demand indexes

Although the dry-up of liquidity was thus roughly equally driven by lower liquidity supply and higher liquidity demand, the implications for risk premiums of the fluctuations in liquidity supply and demand are quite different. Applying the estimates in Goldberg and Nozawa (2021), the decline in liquidity supply between February 28 and March 20 increased the expected one-year-ahead excess return on corporate bonds 3.4 percentage points.14 In contrast, increases in liquidity demand are associated with quantitatively small increases in expected excess returns, which are not statistically significant.

This evolution of the liquidity supply and demand indexes differed markedly from the 2007–09 financial crisis. During the 2007–09 crisis, liquidity supply fell even more dramatically and the decline was much more persistent. Liquidity supply declined from a pre-crisis peak of $60 billion in early 2007 to a low of$13 billion in December 2008. Liquidity supply recovered to $40 billion only in March 2010 and to$50 billion only in March 2011. In addition, liquidity demand did not show a systematic response to stress events during the crisis, sometimes rising and sometimes declining or remaining little changed.

Conclusion

This note studied dealers' liquidity supply and investors' liquidity demand in the corporate bond market during the COVID crisis, using Goldberg and Nozawa's (2021) model of market liquidity. The evolution of the liquidity price for bonds with differing eligibilities for the Federal Reserve's corporate credit facilities (CCFs) provides suggestive evidence that the CCF announcements were important causal drivers of the improvement in market liquidity in late March and April. The model attributes the liquidity dry-up during the COVID crisis about equally to lower liquidity supply and higher liquidity demand. Our analysis suggests that roughly one-fourth of the large decline in value of corporate bonds between February 28 and March 20 was due to reduced dealer balance sheet capacity.

References

Boyarchenko, Nina, Anna Kovner, and Or Shachar (2020). "It's What You Say and What You Buy: A Holistic Evaluation of the Corporate Credit Facilities," Staff Reports 935. New York: Federal Reserve Bank of New York, July (revised November 2020).

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Gilchrist, Simon, Bin Wei, Vivian Z. Yue, and Egon Zakrajšek (2020). "The Fed Takes on Corporate Credit Risk: An Analysis of the Efficacy of the SMCCF," NBER Working Paper Series 27809. Cambridge, Mass.: National Bureau of Economic Research, September.

Goldberg, Jonathan (2020a). "Dealer Inventory Constraints during the COVID-19 Pandemic: Evidence from the Treasury Market and Broader Implications," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, July 17, 2020.

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Goldberg, Jonathan, and Yoshio Nozawa (2021). "Liquidity Supply in the Corporate Bond Market," Journal of Finance, vol. 76 (2), pp. 755–96.

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1. We thank Andrea Ajello, Giovanni Favara, Don Kim, and Steve Sharpe for helpful comments. We also thank FINRA for providing transaction data. FINRA screening was limited to whether there is sufficient aggregation such that no particular dealer is identified. The views expressed here are those of the authors and do not necessarily represent the views of the Federal Reserve Board or its staff. Return to text

2. Regarding corporate bond mutual funds, see Falato, Goldstein, and Hortaçsu (2020) and Ma, Xiao, and Zeng (2020). Regarding Federal Reserve interventions, see Boyarchenko, Kovner, and Shachar (2020), Gilchrist et al. (2020), O'Hara and Zhou (2020), Sharpe and Zhou (2020), and Haddad, Moreira, and Muir (forthcoming). An additional question is to what extent the liquidity dry-up and the spike in corporate bond spreads are related (e.g., Nozawa and Qiu (forthcoming)). Return to text

3. Regarding the connections between welfare, dealer profits, and liquidity supply and demand, see Kargar et al. (2020). Liang (2020) reviews the literature and discusses potential reforms. Return to text

4. The differences in eligibility related to credit rating and remaining maturity. Return to text

5. Risk premiums are high when dealers' balance-sheet capacity is low not only because investors value market liquidity (the ability to transact in large quantities at low cost) but, perhaps more importantly, because dealers act as a marginal investor and provider of secured financing to investors. For a quantitative equilibrium model, see Goldberg and Nozawa (2021). See also, among others, Gromb and Vayanos (2018), Kondor and Vayanos (2019), He, Nagel and Song (2020), and Infante and Saravay (2020). Return to text

7. Many common measures of liquidity such as bid-ask spreads and price-impact measures are also affected by dealer inventory constraints but "contaminated" by other factors such as asymmetric information about issuers. See Vayanos and Wang (2013) for a review of liquidity measures and the factors driving them. This note focuses on liquidity measures from Goldberg and Nozawa (2021) that have been empirically and theoretically connected to dealer inventory constraints. Return to text

8. For issuers with between 7 and 15 issues outstanding, we fit a four-parameter version of the Svensson (1994) yield-curve model, and for issuers with more than 15 issues outstanding, we fit the full 6-parameter Svensson model. Return to text

9. As expected, noise in the corporate bond market is generally much higher than in the Treasury market, for which noise averages 2.3 basis points over the same period (Goldberg (2020a)). Return to text

10. Many factors might have differentially affected IG and HY liquidity over this period, highlighting the need for caution in attributing the evolution of our measures to specific announcements. In particular, the PMCCF and SMCCF were announced concurrently with announcements regarding purchases of Treasury and commercial mortgage-backed securities, the Term Asset-Backed Securities Loan Facility, and other measures; these announcements, while not directly bearing on the corporate bond market, could nonetheless have affected IG and HY liquidity differently. Return to text

11. Eligibility for the PMCCF was restricted to bonds with less than four years remaining maturity. Return to text

12. Goldberg (2020b) performs a similar analysis for the Treasury market, rather than the corporate bond market, finding that liquidity supply shifts have been associated with persistent changes in aggregate liquidity across asset classes and changes in corporate financing conditions. In contrast, liquidity demand shifts have historically been associated with only transitory changes in market liquidity and little, if any, change in corporate financing conditions. Goldberg (2020a) extends this analysis to the COVID crisis. Return to text

13. Goldberg and Nozawa (2021) makes sense of this surprising result using an equilibrium model in which dealers provide liquidity and serve as a marginal investor in the corporate bond market. Negative liquidity supply shocks capture tight dealer inventory constraints, which affect the willingness of dealers both to provide liquidity and to bear aggregate risk not directly related to liquidity (such as aggregate default risk). Indeed, in the quantitative equilibrium model, most of the liquidity supply risk premium arises through the latter channel. The liquidity supply risk premium also reflects that liquidity supply shocks are estimated to have very persistent effects on the price and quantity of liquidity, whereas liquidity demand shocks have fairly transitory effects. Return to text

14. We obtain the estimated increase in the one-year-ahead expected excess return by multiplying (1) the sum of liquidity supply shocks between February 28 and March 20; (2) the percentage change on impact of dealer gross positions, in response to a liquidity supply shock, from Figure 3, panel A of Goldberg and Nozawa (2021); (3) the estimated coefficient on log dealer gross positions for liquidity-supply-dominated periods in table VII, panel C2, "without crisis" column for 52-week horizon. This estimate is a reasonable one because liquidity supply shocks have quite persistent effects on liquidity supply and the time horizon over which we are summing shocks (less than one month) is relatively short. Fully accounting for the dynamic response of positions implies an estimated increase in the expected one-year-ahead excess return on corporate bonds of 3.6 percentage points. Note that the aggregate return forecasting exercise reported in table VII, panel C2 controls for variables considered informative about expected returns: the term spread, the dividend-price ratio, the variance risk premium, and an option-based skewness measure. Return to text