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There are at least two reasons to think that the corporate bond market in aggregate could experience liquidity strains in such a scenario.
First, a publicized risk event like FCF’s announced liquidation may raise expectations of redemptions at other funds.
This group of bonds was more likely to be investment grade than other quintiles, suggesting that their positive performance reflected a flight to safety.
The chart also shows that the bonds with the lowest returns on December 11 (those in the bottom quintile) had already been suffering steady losses in the months prior.
Lastly, we average the individual bond liquidity measures by quintile.
Note that, while FCF’s liquidation was announced December 9, the news did not become public until late on December 10, and market commentary suggests that the initial market reaction came December 11.
Bid-ask spread and round-trip cost (Dick-Nielsen, Feldhutter, and Lando 2012) capture the cost of buying and selling the same bond in quick succession.
The next chart shows that bid-ask spreads and round-trip costs were highest for the low- and high-return groups even prior to the event window.
We then sort bonds into quintiles of performance on December 11, as measured by their return relative to their average price the previous day, so as to examine bonds grouped by their price sensitivity to news about Third Avenue.
The medium group, which had historically better liquidity, did not experience liquidity deterioration on December 11.
While our analysis focuses on price-based measures of liquidity (such as bid-ask spread and round-trip cost), market illiquidity is also often described in terms of the time needed to sell a large quantity of a given security.
Rising credit spreads, increased costs for default insurance, declining commodity prices, uncertainty about global demand, and a possible change in the Federal Reserve’s monetary policy stance were all common themes affecting markets at the time.
Against that backdrop, a highly observable shock like FCF’s liquidation could lead to a broad-based repricing of risk and a subsequent need to hedge and reduce exposures, further increasing the demand for immediacy.