Market liquidity with reference to emerging market bonds and funds is getting a lot of attention of late as credit quality is more closely scrutinized due to the massive inflows into this asset class.
Drawing from our outline in the previous article, a decline in market liquidity can have the following impact:
Increase in transaction costs: A major economic, geopolitical event or a change in market structure may lead to a rise in transaction costs.
Delayed transaction execution: A move towards illiquidity is signified by long delays in execution of buy or sell orders due to a noticeable decline in transaction volume.
Surging price volatility: Price of a securities witnesses large bouts of volatility when liquidity is declining as either buyers or seller far outnumber the other. Though a liquidity squeeze causes price volatility, the relationship in reverse is not necessarily true, i.e., volatility does not automatically indicate low liquidity.
Measures of liquidity in financial markets
Though several measures of liquidity are used by market participants, the two which see the most frequent mention are:
Bid-ask spread: It measures the difference between the highest price offered by a buyer and the lowest price asked for by the seller.
An increase in the spread is considered to be indicative of a decline in liquidity as it signifies a rising gap between price assessments among various participants which can lead to reduced transactions, thus impacting the free flow of orders.
Transaction size: If a large transaction is taking too long to go through, or doesn’t go through at all, it can be indicative of liquidity drying up. This is so because when liquidity conditions are hospitable, even large transactions typically go through without little delay and without adversely impacting the security price.
One of the reasons that it’s important to look at liquidity when transacting in emerging market bonds is due to the credit quality. Aside from a few countries like China, Chile, Malaysia, and Poland, most of the countries are rated BBB and below. In adverse conditions, liquidity – as measured by the aforesaid components – may dry up very quickly.
It’s often believed that funds are helping address the liquidity issue that exists in emerging markets. However, this is often not necessarily the case in practice. We’ll look at this scenario more closely in the next article.