March 2020 saw some incredible liquidity problems in the market. These liquidity problems translated into increased volatility and poor securities pricing, especially in the bond market. While the effect of the Coronavirus on stock prices is easy to understand, the impact of a lack of liquidity in the bond markets is more complex.
What is liquidity?
Liquidity refers to the ease of buying and selling securities. Liquidity requires three things: 1) a good amount of buyers and sellers, 2) A somewhat transparent marketplace (enabling good “price discovery”) and 3) a fair amount of whatever it is that is being bought and sold (in this case, bonds).
Bonds often have very tight bid/ask pricing, just a few cents per $1000 of bonds. Can you imagine a car market where a car could be bought for $40,000 and sold for $39, 960? US Treasury bonds trade even tighter than that!
During the first half of March, liquidity evaporated. If an institution wanted to raise cash by selling bonds, there were almost no bidders. Bonds that did trade, traded into very low bids in very thin markets. In other words, there were a lot of sellers and very few buyers. But bonds, like stocks, rely on real trades for price reporting. So, although low priced, the trades that did occur did get reported and portfolios were priced using those prices.
When a portfolio gets priced, and the owner of that portfolio sees prices are down in certain bonds, often the owner wants to sell those bonds. This can exacerbate the downward spiral in price. In addition, perhaps the portfolio has been put up as collateral to a bank in order to get a loan. If the bank sees its collateral portfolio drop in price, it may force the liquidation of that portfolio, also adding to the downward price spiral of bonds.
The Federal Reserve stepped in
Although stocks had several 5-10% price change days in mid-March, we saw several bonds that had a 25% or more price change in a single day. And the more volatile bonds got, the fewer people wanted to own them.
Recently the Federal Reserve stepped in and announced that it will buy bonds, including mortgage-backed bonds, Treasury bonds, and corporate bonds. In doing so, it will provide price support and cash to the monetary system. This combination of strong buying and cash additions to the markets helped reduce volatility and added much-needed price stability to the bond markets.
We may not be through the worst of the market downturn, but we have seen an increase in liquidity and a decrease in volatility due to Fed action. As a result, portfolios are more stable and there is less panic selling.