Have Liquidity and Trading Activity in the Canadian Corporate Bond Market Deteriorated?

Introduction

Issuing corporate bonds is a major funding source for Canadian firms: in the first quarter of 2018, bonds and debentures accounted for 27 per cent of the borrowings for non-financial firms and 62 per cent for financial firms, excluding borrowings from affiliates (Statistics Canada 2018).

In recent years, however, the functioning of this market has caused concern for market participants and the Bank of Canada. For example, corporate bond market liquidity is a recurrent theme at the Canadian Fixed-Income Forum (CFIF). Responses to the CFIF Survey on Liquidity, Transparency and Market Access in Canadian Fixed-Income Markets (Bank of Canada 2016) suggested that corporate bond market liquidity declined between 2014 and 2016. In a 2017 speech, Deputy Governor Lynn Patterson argued that post-crisis regulatory reforms changed corporate bond market liquidity and altered investors’ trading behaviour (Patterson 2017).

We find evidence that, since 2010, the liquidity of Canadian bonds has improved and that trading activity has remained stable. Liquidity has improved for safer bonds and remained stable for riskier bonds. We also find that the liquidity and trading activity of bonds issued by banks have improved since 2010, whereas these measures have been stable for other corporate bonds. Finally, the evidence reveals short-lived drops in liquidity: the most serious occurred after the fall in oil prices in 2014–15 and was over by the end of 2016.

Our findings are consistent with previous work by Gungor and Yang (2017) and Fan et al. (2018), showing that the liquidity and trading activity of Government of Canada (GoC) and provincial bonds have been generally stable since 2010. However, Canadian corporate bonds remain significantly less liquid than GoC and provincial bonds and represent a small fraction of trading volume in Canadian fixed-income markets (Investment Industry Regulatory Organization of Canada 2017).

Data and methodology

Our analysis focuses on Canadian-dollar-denominated bonds issued by corporations located in Canada. Following Gungor and Yang (2017), we measure liquidity by calculating one proxy for price impact (Amihud 2002) and one proxy for the bid-ask spread (Roll 1984). For both proxies, a higher value indicates less liquidity. Following Fan et al. (2018), we measure trading activity by the number of trades, the average trade size, the turnover ratio and the share of zero-trade days. Higher values for the number of trades, trade size or turnover ratio indicate increased trading activity. The share of zero-trade days identifies periods of inactivity, with a higher figure indicating that the bond is less frequently traded. Details on the methodology and data sources are in the Appendix.

Liquidity has generally improved

Our proxies for the liquidity of Canadian corporate bonds have gradually improved since 2010 (Chart 1). As of August 2018, they were at post-crisis lows. The two proxies deteriorated during the euro area crisis in 2011, the taper tantrum in 2013 and following the oil price fall in 2014. But in each case, they improved shortly afterward.

Chart 1: Liquidity in the corporate bond market has improved

Sources: Canadian Depository for Securities and Bank of Canada calculations

Since 2010, trading activity has been stable across the corporate bond market. The drops in liquidity seem to have had only a small impact on trading activity, if at all. The number of trades and trade size have shown an increasing trend (Chart 2), but the turnover ratio and the zero-trade days measure have remained stable (Chart 3). This suggests that the increase in the number of transactions has followed the growth of the corporate bond market.

Chart 2: The number of trades and trade size have increased

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 3: Zero-trade days and turnover have been stable

Sources: Canadian Depository for Securities, Thomson Reuters and Bank of Canada calculationsLast observation:

The liquidity of riskier bonds has not deteriorated

The Canadian corporate bond market appears to function well in general, but responses to the CFIF survey suggest that the liquidity of riskier, higher-yielding bonds has deteriorated more than that of safer, lower-yielding ones. To investigate this, we categorize one-third of corporate bonds with the narrowest spreads (difference in yield) relative to Government of Canada bonds as “safer” bonds, and one-third with the widest spreads as “riskier” bonds.

We find that safer bonds are now more liquid than in 2010, but that the liquidity of riskier bonds has fluctuated around the same level on average (Chart 4). The difference in the trends for the two segments could explain why some survey respondents reported a divergence between these market segments.

We also find that trading activity has been stable for both safer and riskier bonds since 2010, as measured by the turnover ratio (Chart 5c). However, the average number and size of trades have increased more for safer than for riskier bonds (Charts 5a and 5b). This implies that, for both types, the number and size of trades of corporate bonds have grown proportionally with the issue size of corporate bonds, which has increased since 2010. Finally, the share of zero-trade days is roughly stable for both safer and riskier bonds (Chart 5d).

Chart 4a: Price impact has improved for safer bonds and has fluctuated around the same level for riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 4b: The bid-ask spread has improved for safer bonds and has fluctuated around the same level for riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 5a: The number of trades has increased more for safer than for riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 5b: Trade size has increased more for safer than for riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 5c: The turnover ratio has been stable for both safer and riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 5d: Zero-trade days have been stable for both safer and riskier bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Bank bonds are increasingly liquid

The corporate bond market encompasses a very diverse set of bonds; the evolution of liquidity may have differed for bonds issued by different types of firms. Indeed, we find that the liquidity and trading activity of bonds issued by banks have improved significantly since 2010, but for bonds in other sectors, liquidity has improved less and their trading activity has remained stable.

We classify the issuers of bonds into three sectors: banks, non-bank financial corporations and non-financial corporations. Each sector represents approximately one-third of total outstanding Canadian corporate bonds. The relative share for each sector has remained stable since 2010. In Canada, the six largest banks accounted for 88 per cent of outstanding bank bonds as of January 2018. These “Big Six” banks (the Bank of Montreal, the Bank of Nova Scotia, the Canadian Imperial Bank of Commerce, the National Bank of Canada, the Royal Bank of Canada and TD Bank Group) all rank among the 11 largest publicly traded corporations in Canada by total assets. They generally issue large bonds with high credit ratings (ranging from A to AA).

Across sectors, bonds issued by banks enjoy the highest level of liquidity and trading activity, and the difference has become wider since 2010. Liquidity improved markedly for bank bonds between 2010 and 2014; since then, the proxies have remained low and exhibit little volatility (Chart 6). The liquidity of bonds issued by firms in other sectors has improved less and has been more volatile. Trading activity measures have also improved significantly for bank bonds but not for those in other sectors (Chart 7).

Chart 6a: The price impact of bank bonds has been lower than that of other corporate bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 6b: The bid-ask spread of bank bonds has been lower than that of other corporate bonds

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 7a: The number of trades has increased for all corporate bond sectors

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 7b: Trade size has increased for bonds issued by banks

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 7c: The turnover ratio has increased for bonds issued by banks

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Chart 7d: Zero-trade days have declined for bonds issued by banks

Sources: Canadian Depository for Securities and Bank of Canada calculationsLast observation:

Conclusion

We track the evolution of the corporate bond market since 2010 using liquidity proxies and trading activity. Overall, liquidity has been improving and trading activity has been stable. Drops in liquidity have been short-lived during this period. Improvements in liquidity have been concentrated in safer corporate bonds and in bonds issued by banks. However, the liquidity and trading activity of riskier bonds and bonds issued by firms outside the banking sector have been stable. Finally, these findings do not support the notion that the liquidity of the Canadian corporate bond market has significantly deteriorated in recent years.

Appendix

The liquidity and trading activity metrics are computed using data from Thomson Reuters (TR) and the Canadian Depository for Securities (CDS). The TR data are used for bond characteristics, such as issue date, maturity date, coupon rate and amount outstanding. CDS data are used for bond transaction information, including the date, price and quantity for each corporate bond trade. The sample period is from January 2010 to August 2018.

We exclude bonds issued by the federal or provincial government agencies, or those explicitly guaranteed by these governments. We include bonds that have traded at least once in the secondary market. We include institutional trades only, with a transaction size of at least $100,000. Our statistics show that, on average, from 2010 to 2018, retail trades in the Canadian corporate bond market accounted for more than 50 per cent of the number of trades but less than 1.3 per cent of total amount of bonds traded. The liquidity and trading activity measures are computed for individual bonds.

We use weekly transaction data to construct the liquidity metrics, since many corporate bonds do not have multiple transactions every day. Fontaine et al. (2017) find that the price-impact and bid-ask-spread proxies measure liquidity reliably, even for bonds that are traded less frequently.

Amihud’s illiquidity ratio

$$Amihud_{i,d}=Average\left(\frac{|r_{i,t}|}{DVOL_{i,t}}\right),$$

where \(r_{i,t}\) and \(DVOL_{i,t}\) are the return and dollar value of trading volume, respectively, for bond \(i\) at time \(t\). The transaction-level illiquidity ratio is averaged over a day \(d\) to find the daily illiquidity ratio. The higher the illiquidity ratio, the less liquid the bond.

Roll’s effective spread

$$Roll_{i,t}=2\sqrt{-Cov(r_{i,t},r_{i,t-1})},\,\,if\,Cov(r_{i,t},r_{i,t-1})<0,$$

where \(r_{i,t}\) is the return of bond \(i\) at time \(t\) computed from consecutive trades.

Turnover ratio

$$Turnover_{i,t}=\frac{Trading\,volume_{i,t}}{Outstanding_{i,t}},$$

where \(Trading\,volume_{i,t}\) is the product of the number of trades and average trade size, and \(Outstanding_{i,t}\) is the average outstanding amount for month \(t\).

References

  1. Amihud, Y. 2002. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets 5 (1): 31–56.
  2. Bank of Canada (2017). “Vulnerability 3: Fragile Fixed-Income Market Liquidity.” Financial System Review (June): 16–17.
  3. Bank of Canada. 2016. “CFIF Survey Results on Liquidity, Transparency and Market Access in Canadian Fixed Income Markets.” Canadian Fixed-Income Forum (October).
  4. Fan, C., S. Gungor, G. Nolin and J. Yang (2018) “Have Liquidity and Trading Activity in the Canadian Provincial Bond Market Deteriorated?” Bank of Canada Staff Analytical Note No. 2018-30.
  5. Fontaine, J.-S., J. Gao, J. Sandhu and K. Wu. 2017. “Do Liquidity Proxies Measure Liquidity in Canadian Bond Markets?” Bank of Canada Staff Analytical Note No. 2017-23.
  6. Gungor, S. and J. Yang. 2017. “Has Liquidity in Canadian Government Bond Markets Deteriorated?” Bank of Canada Staff Analytical Note No. 2017-10.
  7. Investment Industry Regulatory Organization of Canada. 2017. Corporate Bond Markets: Liquidity Determination and Overview.
  8. Patterson, L. (2017). “Markets Calling: Intelligence Gathering at the Bank of Canada.” Speech at the CFA Society Calgary, Calgary, Alberta, June 28.
  9. Roll, R. 1984. “A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market.” Journal of Finance 39 (4): 1127–1139.
  10. Statistics Canada. 2018. “Quarterly Balance Sheet and Income Statement, by Industry,” Table 33-10-0007-01. Available at https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3310000701.

Avis d’exonération de responsabilité

Les notes analytiques du personnel de la Banque du Canada sont de brefs articles qui portent sur des sujets liés à la situation économique et financière du moment. Rédigées en toute indépendance du Conseil de direction, elles peuvent étayer ou remettre en question les orientations et idées établies. Les opinions exprimées dans le présent document sont celles des auteurs uniquement. Par conséquent, elles ne traduisent pas forcément le point de vue officiel de la Banque du Canada et n’engagent aucunement cette dernière.