Board of Governors of the Federal Reserve System

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.

The top panel of Figure 4 shows the evolution of dealer gross positions since 2002, when the TRACE data began. The bottom panel shows gross positions during the COVID crisis. Dealer gross positions declined moderately over the course of the COVID crisis, from $43 billion in January to $38 billion at its COVID-crisis trough in May. In late 2020, the quantity of liquidity more than retraced its COVID-crisis decline. The liquidity quantity averaged $46 billion in January 2021. Figure 5 shows the evolution of dealer gross positions with different credit ratings (top panel) and with different remaining times to maturity (bottom panel). The moderate decline in dealer gross positions was driven mostly by IG bonds and bonds with greater than five years remaining maturity.

Figure 4: Dealer gross positions in the corporate bond market

Figure 5: Dealer gross positions, by credit rating and remaining time to maturity

Liquidity Supply and Demand

We next use a model of noise and dealer gross positions to infer shifts in liquidity supply and demand using a vector autoregression (VAR) and simple sign restrictions. A supply shift is assumed to lead to opposite-sign changes in price and quantity. A demand shift is assumed to lead to same-sign changes in price and quantity.¹² Goldberg and Nozawa (2021) describes this methodology in detail.

We define the liquidity supply index as the quantity of liquidity that (according to the model) dealers would provide if the price of liquidity were 20 basis points. Similarly, we define the liquidity demand index as the quantity of liquidity that investors would demand if the price of liquidity were 20 basis points. An increase in the liquidity supply index thus captures an outward shift in liquidity supply. Similarly, an increase in the liquidity demand index captures an outward shift in liquidity demand.

The usefulness of this decomposition is highlighted by the evidence presented in Goldberg and Nozawa (2021), which shows that liquidity supply, but not liquidity demand, is a priced risk factor. That is, liquidity supply shocks help to explain the cross-section of expected corporate bond returns; investors demand higher returns on bonds that have low returns when liquidity supply is low. In addition, liquidity supply is informative about future aggregate corporate bond returns; expected excess returns on corporate bonds are higher when liquidity supply is low. In contrast, their paper does not find evidence that liquidity demand is a priced risk factor—liquidity demand is not informative about cross-sectional or time-series variation in expected excess returns on corporate bonds.¹³

Figure 6 shows the evolution of our liquidity supply and demand indexes over the past two decades (top panel) and during the COVID crisis (bottom panel). The liquidity supply index fell from pre-crisis levels near $50 billion to a trough of $29 billion on March 20. Liquidity supply recovered sharply after the CCF announcements and exceeded $40 billion in early May. At the end of 2020, liquidity supply regained its $50 billion pre-crisis level. Liquidity demand rose from pre-crisis levels near $35 billion to a peak of $53 billion on March 20, the same day as the trough of liquidity supply. Liquidity demand declined after the CCF announcements before increasing in late 2020 to levels near $43 billion by year-end.

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).

Brunnermeier, Markus K., and Lasse Heje Pedersen (2009). "Market Liquidity and Funding Liquidity," Review of Financial Studies, vol. 22 (6), pp. 2201–38.

Duffie, Darrell (2010). "Presidential Address: Asset Price Dynamics with Slow‐Moving Capital," Journal of Finance, vol. 65 (4), pp. 1237–67.

Falato, Antonio, Itay Goldstein, and Ali Hortaçsu (2020). "Financial Fragility in the COVID-19 Crisis: The Case of Investment Funds in Corporate Bond Markets," NBER Working Paper Series 27559. Cambridge, Mass.: National Bureau of Economic Research, July (revised May 2021).

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.

Goldberg, Jonathan (2020b). "Liquidity Supply by Broker-Dealers and Real Activity," Journal of Financial Economics, vol. 136 (3), pp. 806–27.

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

Gromb, Denis, and Dimitri Vayanos (2018). "The Dynamics of Financially Constrained Arbitrage," Journal of Finance, vol. 73 (4), pp. 1713–50.

Grossman, Sanford J., and Merton H. Miller (1988). "Liquidity and Market Structure," Journal of Finance, vol. 43 (3), pp. 617–33.

Haddad, Valentin, Alan Moreira, and Tyler Muir (2020). "When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed's Response," NBER Working Paper Series 27168. Cambridge, Mass.: National Bureau of Economic Research, May.

He, Zhiguo, Stefan Nagel, and Zhaogang Song (2020). "Treasury Inconvenience Yields during the Covid-19 Crisis," NBER Working Paper Series 27416. Cambridge, Mass.: National Bureau of Economic Research, June (revised November 2020).

Infante, Sebastian, and Zack Saravay (2020). "What Drives Treasury Re-use? (PDF)" Finance and Economics Discussion Series 2020-103. Washington: Board of Governors of the Federal Reserve System, October.

Kondor, Péter, and Dmitri Vayanos (2019). "Liquidity Risk and the Dynamics of Arbitrage Capital," Journal of Finance, vol. 74, pp. 1139–73.

Kargar, Mahyar, Benjamin R. Lester, David Lindsay, Shuo Liu, Pierre-Olivier Weill, and Diego Zúñiga (2020). "Corporate Bond Liquidity During the Covid-19 Crisis," NBER Working Paper Series 27355. Cambridge, Mass.: National Bureau of Economic Research, June (revised May 2021).

Liang, J. Nellie (2020). "Corporate Bond Market Dysfunction during COVID-19 and Lessons from the Fed's Response (PDF)," Hutchinson Center Working Paper 69. Washington: The Brookings Institution, October.

Nozawa, Yoshio, and Yancheng Qiu (forthcoming). "Corporate Bond Market Reactions to Quantitative Easing during the COVID-19 Pandemic," Journal of Banking and Finance.

O'Hara, Maureen, and Xing (Alex) Zhou (forthcoming). "Anatomy of a Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis," Journal of Financial Economics.

Sharpe, Steven A., and Alex X. Zhou (2020). "The Corporate Bond Market Crises and the Government Response," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 7.

Svensson, Lars E.O. (1994). "Estimating and Interpreting Forward Interest Rates: Sweden 1992-1994," NBER Working Paper Series 4871. Cambridge, Mass.: National Bureau of Economic Research, September.

Vayanos, Dimitri, and Jiang Wang (2013). "Market Liquidity—Theory and Empirical Evidence," in George M. Constantinides, Milton Harris, and Rene M. Stulz, eds., Handbook of the Economics of Finance, Vol. 2B. Amsterdam: Elsevier, pp 1289–1361.