The Covid-19 and the economy
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The deterioration in liquidity conditions due to stress and forced sales was noticeable in both the equity and bond markets. Different indicators of liquidity measurement, in particular the bid / ask ranges, all lead to the same conclusion: today we see less liquidity in mid-cap stocks and, this which is much less intuitive, less liquidity on equities of large American or European capitalizations (as measured on the S&P 500 and Eurostoxx 50 indices). Business credit was also affected.
Credit: a marked drop in liquidity
All credit segments were impacted. The phenomenon was exacerbated on US investment-grade short-term credit for technical reasons. Investors use this segment (and US Treasuries) as collateral for leveraged positions. In a volatile market environment, when investors face margin calls, they liquidate these positions.
As this is also a market segment also used by investors to place cash and where they have less tolerance for risk, there has been a snowball effect on the sales of these positions. When liquidity is reduced, bid / ask ranges tend to increase, and buying and selling of positions becomes more problematic in the event of spikes in volatility. This phenomenon was observed in the drop in performance of bond ETFs (exchange-traded funds). On the other hand, the CDS indices stood out from bonds thanks to the stability of their liquidity profiles.
CDS indices remained liquid
First, the transaction costs (bid / ask range) of the CDS indices represent a fraction of the transaction costs of conventional bonds, which come to affect their performance, particularly in the high yield segment. For “high yield” CDS indices, the “bid / ask” range is between 15 and 25 cents. Next, the CDS indices represent around 80% of the daily volumes traded on the credit market in EUR. Finally, the volumes traded on the CDS indices increase during the stress phase. During the stressful period of March 2020, the volumes on the high-yield CDS index in Europe rose from 5 billion per day on average to 20 billion per day, an increase of 300%. For the investment-grade index in the United States, volumes rose from 24 billion to 118 billion, an increase of almost 400%.
Why choose liquidity?
In stress phases, more liquid instruments behave better. And conversely, less liquid instruments behave less well … This was clearly confirmed during the period of stress linked to Covid-19. CDS indices held up better than the traditional bond market as measured by bond indices (which are by nature non-investable) or by ETFs (investable). This advantage of liquidity is expressed in phases of stress but also in phases of rebound, when investors unwind the credit hedges they have been able to put in place, and in the medium term notably through transaction costs. almost zero.
The Covid-19 crisis was a life-size crash test for the successful CDS indices. It thus validates the liquidity advantages of these instruments for investors in addition to or in replacement of traditional bond strategies.
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