Konstantinovsky 2016

Measuring Bond-Level Liquidity
VADIM KONSTANTINOVSKY, KWOK YUEN NG,

AND BRUCE D. PHELPS
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T
VADIM ransaction cost considerations number of bonds. These are automatically
KONSTANTINOVSKY enter the decision-making process collated, parsed, and saved as part of the
is a director at Barclays,
of all participants in fixed-income Barclays index validation process. On any
Inc. in New York, NY.
vkonstan@barclays.com secondary markets. The timing given day, many more bonds are quoted than
and size of individual trades are inf luenced traded. Bid–ask spreads themselves do not
KWOK YUEN NG by the trade-off between the cost of trading incorporate the market impact of large trades,
is a director at Barclays, and the opportunity cost of not trading. which is often of interest, but many traders
Inc. in New York, NY. Yet, although its importance is recognized, and investors find bid–ask spreads to be suf-
kwok-yuen.ng@barclays.com
liquidity is not easy to measure. ficiently positively correlated with market-
BRUCE D. P HELPS Academics and policymakers are inter- impact costs.
is a managing director ested in aggregate market liquidity and use Barclays’ bond-level liquidity mea-
at Barclays, Inc. in a variety of variables to study or monitor sure, Liquidity Cost Score (LCS), is defined as
New York, NY. it. Investors, however, are concerned about the cost of an institutional-size, round-trip
bruce.phelps@barclays.com
the liquidity of their portfolios and indi- transaction; therefore, a lower LCS signifies
vidual holdings. How does one measure the better liquidity. LCS is expressed as a per-
liquidity of a bond? There has been some suc- centage of the bond’s price and can be aggre-
cess in measuring liquidity in transparent and gated across bonds and compared over time.
active equity markets; but in bond markets, Portfolio managers can use this measure to
it’s a challenge because of the sheer number quantify the liquidity of their holdings and
of instruments and the infrequent trading compare them to a benchmark. A consis-
in most of them. Moreover, unlike stocks, tent quantitative metric facilitates rigorous
which largely trade in exchange-based mar- studies of market liquidity and other market
kets, bonds still trade mostly over the counter. phenomena.
Although some markets (notably USD credit)
have regulations requiring that trades be LCS METHODOLOGY
reported, transaction data is scarce in others.
In 2009, Barclays created a bond-level Traders post bid and ask quotes in two
liquidity measure to fill a gap in the bond different ways: as yield spreads over Trea-
investor’s toolbox. Because of the dearth suries or as bid and ask prices. The former
of transaction data, this measure relies on are spread quotes (typical for USD Investment
simultaneous two-way quotes from Barclays’ Grade Credit), and the latter are price quotes
traders who make markets in a significant (most USD High Yield and non-USD bond
116 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

markets). As a result, LCS is computed in one of two, to meet several conditions—for example, to be a large
conceptually identical, ways: and recent issue and to have a maturity close to one
of the main issuance points (2-, 5-, 10-, and 30-year).
LCS = ( d p d k p d) However, if a bond has extremely high trading volume
× OASD if bond is spread-quoted (1) (high-volume criterion), these conditions are waived.
Ask price − Bid price Sometimes, trader quotes are indications, as opposed
LCS = if bond is price-quoted
r (2) to live, transactable, two-way markets. The LCS method-
Bid price ology determines whether a quote is realistic or an indi-
cation. In the latter case, the model widens the bid–ask
As an example, in March 2016, the ALCOA 5.4%
spread to ensure it is not too narrow compared with the

of 4/5/2021, a Ba-rated bond issued in 2011, was quoted
“true” market. Bid–ask spreads are never tightened, in
with a bid price of 99.89 and an ask price of 101.01. Its
the spirit of making LCS a conservative measure.
LCS is calculated as (101.01 – 99.89) / 99.89 = 1.121,
Last but not least, a bond may have no two-way
which means it would cost a manager 1.12% of the bond’s
trader quotes at all. Its bid–ask market must be estimated.1
value to execute an immediate round-trip transaction
In the next section, we look at how this is done.
for a “normal-size” amount.
Every month, thousands of simultaneous bid–ask
quotes are collected and matched to the Committee on LCS MODEL FOR NONQUOTED BONDS
Uniform Security Identification Procedures (CUSIPs).
In the absence of a trader-quoted market for a bond,
For every bond, LCS corresponding to each quote is
the model estimates what investors would likely have to
computed and, at the end of the month, averaged into
pay to trade this bond. The model works as follows:
the bond’s monthly LCS value.
Monthly cross-sectional regression analysis is used
Any particular bond’s bid–ask spread is unlikely to
to estimate a statistical relationship between quoted
be the “effective” market—that is, the highest bid and
bonds’ attributes and their observed LCS. It is assumed
lowest offer across all broker/dealers. A trader’s quotes
that the same relationship holds for nonquoted bonds,
for a particular bond are often inf luenced by his inven-
and their LCS is calculated accordingly. Then, LCS is
tory or outlook. A long position may be quoted with a
adjusted upward, because a bond without a single trader
tighter spread to entice a bid, and vice versa. Investors,
quote in a month is likely to be less liquid than a quoted
however, choose their counterparty and shop for best
bond with similar attributes.2 These models vary across
execution, so LCS may overstate “best-execution” cost.
markets. Attributes important for, say, EUR covered
However, Barclays’ material presence in fixed-income
bonds may not matter, or indeed even exist, in the USD
markets ensures that its quotes are not too far from
credit market. So although the key set is usually the
market levels. Moreover, idiosyncratic circumstances
same, the econometric models ref lect specific properties
are unlikely to persist throughout a whole month, and
of each market. We will now use the large and diverse
monthly averaging largely eliminates their inf luence.
USD IG corporate market to illustrate the LCS mod-
Nevertheless, LCS is a conservative measure of transac-
eling approach.
tion costs.
Investors will find most attributes used in the LCS
The quality of trader quotes is a key factor and
model intuitive. Recent and large issues are cheaper to
may be uneven across bonds. Actively traded issues are
trade than seasoned and small ones, so bond age and
likely to be quoted both at executable levels and uni-
issue size matter. High-risk securities (i.e., bonds with
formly among broker/dealers. The LCS methodology
wide spreads) tend to be costlier to trade than low-risk
uses the term benchmark to describe such bonds. Bench-
ones. A trader taking a position in a high-risk bond will
marks are closely monitored high-profile securities with
quote wider bid–ask spreads, so some measure of credit
good two-way f low. A trader is unlikely to quote such
risk must be among the model variables.
a bond carelessly because it would signal inattention
The decision on whether to use a certain attribute
to the market or weak market-making capability. The
is based on its relationship with observed LCS. The “heat
benchmark status is determined by two criteria, “on the
map” in Exhibit 1 segments the universe of trader-quoted
run” and “high volume”. To be on the run, a bond has
SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 117

EXHIBIT 1
Average LCS by Issue Size and Age, USD IG Corporates, March 2016
Note: Buckets with fewer than five bonds are not shown.
corporates by age and issue size while controlling for Next, we look at the historical relationship between
maturity (hence, four tables), with darker backgrounds observed LCS and credit spread (OAS). The strength and
for higher LCS. Two clear gradients emerge: LCS stability of the relationship (Exhibit 2) is striking. Clearly,
increases for higher age and lower issue size. credit spread has to be one of the model variables.
EXHIBIT 2
LCS vs. OAS, USD IG Corporates, Trader-Quoted Benchmarks, January 2007–March 2016
Source: Barclays Research.

model controls for volume because it can become impor-
When liquidity is defined as the cost of trading, one
tant during periods of market turbulence.
needs to examine how trading volume affects it. Intuitively,
one might assume a negative relationship between LCS Two proxies of market risk are VIX and Treasury
over Eurodollar (TED) spread. Yet they are highly cor-
and volume; indeed, this was true during the credit crisis,
when LCS and volume moved—or rather jumped—in related with OAS (Exhibit 4), so including them in the
model is redundant.
opposite directions. However, in the recent, more normal
environment, there has been no meaningful relationship Some of the more important variables in the model
are Option-Adjusted Spread Duration (OASD) × OAS,
between volume and LCS. The scatter plot of LCS versus
LCS benchmark status, industry sector and quality, age,
volume for trader-quoted corporates in Exhibit 3 shows
issue size, trading volume, and price distance from par. The
no discernible relationship between the two. Yet the LCS
coefficients of these factors are almost always
statistically significant. The R 2 of the regression
EXHIBIT 3 usually ranges between 60% and 80%.
LCS vs. TRACE Trading Volume, USD IG Corporates, Trader- Liquidity in different markets is driven
Quoted Benchmarks, March 2016 by factors specific to that market. For example,
the country of issuer does not matter for USD
corporates but is important for Pan-Euro cor-
porates, so models for different markets are
implemented individually.3
PROPERTIES OF LCS
Investors are concerned not only with a

bond’s current LCS, but with its variability.
Portfolio managers want to know what the
LCS of their portfolio is likely to be in the
near future, when they may have to transact.
“Current liquidity conditions” should ref lect
EXHIBIT 4
LCS vs. VIX, USD IG Corporates, Trader-Quoted Benchmarks, January 2007–March 2016

not only the aggregate LCS level, but also intramarket testing this relationship yields highly significant coeffi-
dispersion. The stability of relative LCS rankings within cients for both IG and HY.
a market is also important: How likely is a bond in a In addition to the systemic relationship between cur-
particular LCS quintile to be there next month? Is it rent liquidity conditions and short-term liquidity uncer-
possible to compare the liquidity of different markets? tainty, portfolio managers are concerned about liquidity
tail risk—that is, being stuck with bonds that are costly
Relationship between LCS Level to trade. To examine this, we sort the bonds in each LCS
and LCS Volatility bucket into percentiles based on their absolute one-month
ΔLCS and then measure each LCS bucket’s 95th and 99th
High spread levels are usually accompanied by high percentile of one-month ΔLCS. For both IG and HY,
absolute short-term spread volatility. Spread is also a high-LCS buckets show higher liquidity tail risk.
major driver of transaction costs. When market condi-
tions deteriorate, traders demand more compensation for Cross-Sectional Distribution
holding inventory. Hence, one might expect the short- and Persistence of LCS
term volatility of LCS to be proportional to its level.
This relationship is investigated on a sample of In broad markets, such as USD credit, there is a
about 450,000 trader quotes for bonds in the USD IG wide dispersion of LCS, which parallels equally wide
Credit and high-yield (HY) indexes. Separately for IG distributions of factors that influence LCS—for example,
and HY, each bond’s one-month ΔLCS is measured, issue size, age, and spread. The LCS distribution contains
forming a sample of LCS–ΔLCS pairs. Bonds are then valuable information about market conditions. LCS dis-
sorted into 10 buckets, based on their beginning-of-the- persion can change significantly. Exhibit 6 shows cross-
month LCS. For every such bucket, average absolute sectional distributions for the pre-crisis month of July
value, standard deviation, and distribution of ΔLCS are 2007—widely considered a time of very good market
computed. liquidity—and the turbulent November 2008. The
Exhibit 5 shows that during the same stressful properties of the two distributions could not be more
period, the relationship is both strong and linear, except different. The March 2016 distribution lies between the
for the sparsely populated high-LCS buckets. A regression two extremes.
EXHIBIT 5
LCS Level and Liquidity Risk in Turbulent Markets, USD IG Credit, December 2007–December 2009

EXHIBIT 6
Historical Cross-Sectional Frequency Distribution of LCS, USD IG Credit
Another important question concerns the stability Cross-Market Liquidity Comparisons

of LCS for groups of similar securities. For any particular
bond, LCS may change significantly but, on average, Portfolio managers are also interested in comparing
bonds in a particular place on the liquidity spectrum liquidity across different markets. Exhibit 8 shows his-
should remain there a month later. In other words, how torical time series for USD and EUR corporates. For
persistent is LCS? How quickly do bonds migrate along most of the time period, USD LCS was significantly
the liquidity scale? This question is answered by dividing higher than EUR LCS. Is the EUR corporate market
the Barclays USD IG Credit Index into LCS quintiles more liquid? Although this may be true in an absolute
and measuring transition rates among different quintiles. sense, this is not how portfolio managers look at it. They
Exhibit 7 shows the transition rates for March 2016. In want to know in which market it would be cheaper
normal liquidity regimes, bonds tend to stay in their last- to trade the same bond. Comparing market-level LCS
month’s quintile. Not surprisingly, it is particularly true says little about relative liquidity because the markets
for the most- and least-liquid quintiles (85% and 90%, have different bond characteristics, which invalidates the
respectively). At the peak of the credit and liquidity crisis comparison. For example, if one market largely com-
of 2008, the corresponding rates were 63% and 71%. prises short-duration, newly issued low-spread bonds,
EXHIBIT 7
LCS Quintiles: Transition Rates and Average LCS, USD IG Credit, March 2016 (%)

EXHIBIT 8
Historical LCS of USD and EUR Credit, May 2010–March 2016 (%)
while the other consists mainly of long-duration, sea-

soned high-spread bonds, a lower aggregate LCS of the EXHIBIT 9
first market would be expected. Market Attributes Driving Corporate LCS: USD vs.
The USD and EUR corporate markets differ in EUR, March 2016
several attributes important to LCS. As Exhibit 9 shows,
USD corporates have longer spread duration and wider
spreads. Both contribute to higher LCS. Their product,
used in the LCS model, is more than 1.5 times that of
EUR corporates. In addition, bonds in the USD market
tend to be older and have a smaller issue size. Every one
of these attributes is an important determinant of LCS.
To evaluate the relative liquidity of these markets,
one needs to account for differences in bond attributes. Source: Barclays Research.
This is achieved by regressing the LCS of the
most liquid, trader-quoted USD and EUR
corporates on their age, issue size, OASD × E X H I B I T 1 0
OAS, trading volume, and a dummy vari- USD and EUR Corporates: Cross-Sectional Regression Results,
able that indicates whether the bond is USD March 2016
or EUR. If the coefficient on this variable
is statistically significant, its sign will show
whether the USD market has worse (positive)
or better (negative) liquidity.
Exhibit 10 shows the regression results Source: Barclays Research.
for March 2016. The USD dummy coefficient

is positive and significant, indicating relatively less TES blends LCS and trading volume into a single
liquidity in the USD corporate market, all other things relative score that ref lects both the cost and f low. Within
equal. However, although the average LCS difference one market, bond-level TESs are comparable over time
between USD and EUR LCS is 0.332 (Exhibit 9), more and among bonds, and they come close to representing
than a third of it can be explained by market attri- how traders think about liquidity—that is, in terms of
butes. The true measure of relative liquidity—that is, both transaction costs and market impact. As a relative
the LCS difference between identical bonds in the two measure, TES can serve as a liquidity filter in portfolio
markets—is 0.201. construction. It also helps with backtesting investment
strategies. Using only low-TES bonds in a backtest shows
LCS APPLICATIONS FOR PORTFOLIO how realistic the strategy is in practice, and how achiev-
MANAGEMENT able are its promised returns.
To compute TES, we assign each bond in a partic-
Measuring Bonds’ Relative Liquidity ular market to an OASD-adjusted LCS quintile and to a
monthly trading-volume decile. (LCS is a product of the
LCS is an absolute measure that f luctuates with bid–ask spread and OASD, so the duration adjustment
overall market liquidity, so a time series of a bond’s LCS is necessary for relative-liquidity comparison of bonds
does not show where the bond has stood against its peers with different durations.) Then, these two quantiles are
over time. Another liquidity measure, derived from added, and the sum (ranging from 2 to 15) is mapped to
LCS, is Trade Efficiency Score (TES). TES is a bond-level a TES ranking from 1 to 10 (Exhibit 11).
liquidity rank ranging from 1 (best) to 10 (worst); it The TES buckets differ in the number of bonds
helps to quickly judge a bond’s liquidity relative to sim- and market value. The TES1 bucket comprises approxi-
ilar bonds, both currently and over time. mately 15% of the corporate market by number of bonds
LCS captures the cost of trading but does not and 32% by market value, whereas the TES3 bucket
directly measure trading f low. Many corporate bonds accounts for 7% of bonds and 7% of market value.
trade infrequently, so LCS may not ref lect the diffi- The attributes of bonds in different TES buckets
culty of implementing large or numerous trades. When vary substantially and predictably. By construction,
comparing similar bonds, traders interested in imme- low-TES buckets have bonds with low LCS and high
diate execution may prefer a bond with a high current trading volume. As Exhibit 11 shows, the average LCS
trading volume to a bond with the same LCS but lower for TES1 is less than a third of that for TES10. Its
volume. average monthly trading volume is $392 million per
EXHIBIT 11
Trade Efficiency Scores, Barclays USD IG Corporate Index (ex. 144A), March 2016

bond compared with $1 million for TES10. Low-TES month. Hence, changes in investors’ views affect infre-
buckets tend to be populated by large, recent issues. quently-traded bonds gradually. Eventually, the news
Average issue size decreases dramatically in higher-TES does become fully ref lected in their prices, but the
buckets, while average age increases. delayed adjustment causes lagged returns to be positively
correlated with current-period returns.
Liquidity and Market Efficiency How uniform is price inertia within the corporate
market? This analysis is repeated for each TES bucket.
Market efficiency is an important topic for both In low-TES buckets, lagged excess returns should have
academics and investors. The main characteristic of effi- little explanatory power (i.e., statistically insignificant
ciency is how quickly asset prices ref lect available infor- coefficients and low R2 ); however, in high-TES buckets,
mation; insufficient liquidity is among the reasons why one would expect significant coefficients that explain
they may not. In a liquid market, prices adjust rapidly to a meaningful percentage of the bucket’s excess return
news and changes in portfolio preferences. With many volatility. Exhibit 12 presents the autoregressive model
potential buyers and sellers constantly inquiring, quoting, output by TES bucket, which shows a large variation in
and trading, prices (and, hence, excess returns4) quickly price inertia in the corporate market.
ref lect an equilibrium of many viewpoints. However, For the most liquid bucket, TES1, the lagged ER
if a market has limited quoting and trading activity, the coefficient is statistically zero, and the regression R 2 is
propagation and evaluation of news is slower. Hence, close to zero. TES1 bonds are relatively cheap to trade
one way to assess efficiency is to check for price inertia and have relatively high trading volumes, so it is not
when past returns help explain current-period returns.
To investigate informational efficiency of the
USD IG corporate market, we partition the index into EXHIBIT 12
liquidity strata based on TES. One would expect more
Estimated Autoregression Coefficients by TES
liquid segments to display less price inertia. The com- Bucket, Monthly Returns, February 2007–April 2015
parison of price inertia in various TES buckets can reveal
whether low-TES buckets are indeed more efficient than
high-TES ones.
Price inertia is measured by regressing current-
month excess returns (ER) on previous-month excess
returns.5
ER t = α + β1 × ER t-1 + εt (3)
For a market with no price inertia, the estimated
regression coefficient on the lagged return term would
be statistically insignificant. For example, the one-
month lag coefficient is not significant for the Trea-
sury Index and SPX, so their previous-month returns
do not help explain current-month returns—which is
consistent with the common view that these are very
liquid markets with prices and returns quickly adjusting
to new equilibrium levels. This is not so for the Cor-
porate Index. The lag coefficient (0.34) is statistically
significant, and 11% of the variation in the current-
month returns is explained by the previous-month excess
returns (Exhibit 12). Notes: Based on the AIC, we estimate the model using one lag. Standard
errors are Newey-West with a truncation parameter of 3; t-statistics are
What could explain this pattern in the Corpo- in parentheses. Coefficients in bold are statistically significant at the 5%
rate Index? Unlike Treasury bonds and stocks, many confidence level.
corporate bonds trade rarely or not at all in a particular Source: Barclays Research.

surprising that new information is quickly and fully The approach is to regress bond-level credit spreads
ref lected in their prices and, hence, excess returns. (OAS) on liquidity cost (LCS) and expected default cost
Beyond TES1, the picture quickly changes. For (issuers’ market-quoted five-year credit default swaps
TES2, the coefficient for the lagged ER term is positive [CDS]). The intercept term represents a market-level
(0.28) and statistically significant: The R2 is 7%. Moving risk premium common to all bonds. Exhibit 13 shows
from TES1 to TES2 produces reduction in liquidity, the results of this decomposition from January 2007
confirmed by their LCS and volume (Exhibit 11). As through March 2016.
TES increases, both the lagged ER-term coefficient and Portfolio managers look at spread decomposition
regression R 2 rise. For TES9 and TES10, the lag coef- to gain certain insights. For example, although the OAS
ficient reaches 0.50, with an R 2 of 24%. levels in September 2007 and April 2010 were similar,
To summarize, market efficiency varies signifi- the components of OAS were very different. The OAS
cantly within the corporate market and is determined in September 2007 consisted mainly of a market-wide
largely, if not entirely, by liquidity. Also, the results sug- risk premium, whereas default cost was the main con-
gest that TES and, hence, LCS, do a good job of parti- tributor to OAS in April 2010. During 2008 and early
tioning the market by liquidity. 2009, the risk premium and liquidity cost were the
largest components of average OAS. For buy-and-hold
Credit Spread Decomposition investors, who may not need to sell in the foreseeable
future, the unusually high risk premium and liquidity
Credit spreads compensate credit investors for the components of OAS may have presented an opportunity
possibility of bond default. However, many studies have to add credit exposure.
shown that spreads of credit bonds are generally much
wider than is justified by their subsequent default and Liquidity-Adjusted Tail Risk
recovery experience. One of the explanations for this
“excess” spread is expected liquidity cost. LCS can help In times of market upheavals that trigger massive
illustrate this by allowing the decomposition of a bond’s portfolio liquidations, portfolio managers find it difficult
spread into expected default loss, expected liquidity cost, to realize the mark-to-market value of their holdings.
and “risk premium” components. As a result, actual losses may far exceed the estimates of
EXHIBIT 13
Risk Premium, Default, and Liquidity Components of the USD IG Credit OAS, January 2007–March 2016

traditional value–at–risk (VaR) models based on pub- portfolio (–8.7% vs. –8.1%) due to poorer liquidity. In
lished bid prices. To correct for this, one needs to rec- March 2011, as the markets are returning to normal,
ognize that losses in tail events are exacerbated by high the difference between the tail-risk estimates of the two
transaction costs. LCS allows investors to modify their VaR models is smaller, for both the Liquid Low-OAS
tail-risk models accordingly. One method of adjusting and Illiquid High-OAS portfolio. LCS data for USD
VaR models is to model a bond’s midprice, rather than credit are available back to 2007, so investors have
its bid price, and lower it according to the bond’s LCS liquidity data for the 2008–2009 crisis experience to
to arrive at a bid price more realistic in adverse market adjust their tail-risk models.
conditions.
To illustrate, we apply both a traditional VaR Benchmark Replication

model and the “LCS VaR” model to three structur-
ally similar portfolios of USD corporate bonds—in the Portfolio managers often look for ways to obtain
stressful environment of November 2008 and in March credit index beta exposure. In broad markets with thou-
2011 when markets returned to normal (see Exhibit 14). sands of securities, this is not a trivial task. Although
The first two portfolios differ in risk (OAS) and liquidity good tracking is the main objective, realistic implemen-
(LCS). The spread of the “Illiquid High-OAS” portfolio tation at a reasonable cost is critical. Total return swaps
is about twice as high as that of the “Liquid Low-OAS” on broad credit indexes are often unavailable or expen-
portfolio. Its LCS is higher as well. sive. Credit derivatives tend to track cash indexes poorly.
To control for spread, we created a third portfolio, Yet index replication with cash bonds is not easy because
“Illiquid Low-OAS,” with an OAS similar to that of the it may be hard to decide which bonds are sufficiently
“Liquid Low-OAS” portfolio, but with higher LCS and liquid. A tracking portfolio needs to be rebalanced on a
its tail risk modeled for November 2008. This experi- regular basis, so liquidity is important.
ment asks two questions: In extreme scenarios, how Having a quantitative measure of bond liquidity
much more does it cost to liquidate illiquid bonds com- helps a portfolio manager to objectively select a universe
pared with equally risky but more liquid bonds? And, do of liquid bonds from which to construct a tracking port-
transaction costs affect tail risk in difficult times more folio. Then, the manager can apply a transparent, rules-
than in calm periods? based methodology that relies on stratified sampling. An
Exhibit 14 shows that in November 2008, both example of such liquid proxy is a 50-bond portfolio that
models predict a bigger loss for the Illiquid High-OAS tracks the Barclays USD Credit Index (6,465 bonds as of
portfolio than for either the Illiquid or Liquid Low-OAS March 2016). To construct it, we divide the index into
portfolios. In addition, the LCS VaR model predicts five sectors (basic, consumer, financial, technology, and
significantly larger losses for all three portfolios com- other), and five duration categories (0–3, 3–5, 5–7, 7–10,
pared to the traditional VaR model. Notably, the tra- and 10+). We form “the eligible universe” by selecting,
ditional VaR model, based on spreads only, calculates for each of the resulting 25 buckets, the top 20% most
identical losses for the Liquid Low-OAS and the Illiquid liquid index bonds according to their LCS rank, and
Low-OAS portfolios. The LCS VaR model, however, adding to this set the top LCS quintile of bonds by dura-
predicts a 0.6% bigger loss for the Illiquid Low-OAS tion category. Finally, we select 50 bonds by stratified
EXHIBIT 14
Traditional vs. Transaction-Costs-Adjusted 99% VaR, Test Portfolio Losses (% market value)

sampling to match the contribution to OASD × OAS, Dealer Inventories and Market Liquidity
as well as the market value percentage, of the index in
each of the 25 buckets. Beginning in early 2008, corporate bond dealer
In March 2016, the LCS of the tracking portfolio inventories collapsed after a steady multiyear buildup.
was 0.478 versus 0.896 for the credit index. Since January Higher capital requirements, diminished risk appetite,
2009, it has tracked, out of sample, the index with an and new legislation have kept inventories low. The dra-
average monthly tracking error of just –0.5 bps and a matic decline in inventories was concurrent with an
monthly tracking error volatility of less than a quarter of equally dramatic spread widening.
the index’s excess return volatility over the same period This decline in dealer inventories gave rise to all
kinds of speculation about liquidity consequences. The

(30 bps versus 130 bps).
EXHIBIT 15
Excess Returns of the Liquid Tracking Portfolio vs. the USD IG Credit Index, January 2009–March 2016
EXHIBIT 16
U.S. Dealer Corporate Bond Inventories vs. the Nonfinancial USD IG Corporate LCS, January 2007–December 2012
Source: Federal Reserve Bank of New York, Barclays.

EXHIBIT 17 to the portfolio level and compared over time. A few
LCS vs. Dealer Inventories, Regression Results, LCS applications described in this article illustrate how
July 2009–April 2012 bond portfolio managers can use LCS. Finally, LCS
provides valuable and relevant data for academics and
policy makers studying and monitoring liquidity in
bond markets.
Source: Barclays Research. ENDNOTES

prevailing opinion is that constrained inventories cause a The authors would like to thank Siddhartha Dastidar,
Ariel Edelstein, and Lokesh Munirajulu for their contribution
material reduction in liquidity. Indeed, Exhibit 16 shows
to LCS research and development.
a concurrent jump in LCS. However, most views have 1
Such bonds are a minority in most markets. For
lacked empirical support. LCS helps bring some hard example, in March 2016, 69% of bonds in the USD IG Cor-
evidence to the discussion. porate Index were quoted, of which 24% were benchmarks.
However, regression analysis is needed to control 2
The LCS for a bond without quotes in a particular
for changes in other market factors besides changes in month may not immediately undergo the full adjustment.
inventories: market risk (OAS), trading volume, and The model has a smoothing algorithm that takes into account
dealer distress (TED Spread). Even after accounting for whether the bond was quoted in preceding months.
3
these other factors that could impact LCS, Exhibit 17 In March 2016, Barclays published LCS for about
reveals a significant relationship between LCS and 18,700 fixed-income securities with the total market value
dealer inventories in the immediate post-crisis period, exceeding $47.6 trillion. The LCS asset class coverage includes
confirming and quantifying the negative effect of the the following markets: USD and Pan-Euro investment-grade
and high-yield credit; USD, Pan-Euro and Asia-Pacific nom-
reduced inventories on transaction costs.6 More precisely,
inal and inf lation-linked treasuries and government-related
a $10 billion decline in dealer inventories is associated debt; global covered bonds; USD emerging markets; and
with a 5.2 bps increase in LCS. Assuming 100% annual USD mortgage-backed securities.
credit portfolio turnover, this deterioration in liquidity 4
Corporate excess return is total return less the return
corresponds to a portfolio performance drag of approxi- of a duration-matched Treasury portfolio
mately 5.2 bps a year. 5
All corporate bonds are trader-priced at the end of
each month.
6
CONCLUSION We include quoted bonds only, to eliminate model
dependency.
Liquidity Cost Score (LCS) is a bond-level metric
that provides an objective, quantitative way to mea- To order reprints of this article, please contact Dewey Palmieri
sure individual bonds’ liquidity. LCS can be aggregated at dpalmieri@ iijournals.com or 212-224-3675.

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Measuring Bond-Level Liquidity

VADIM KONSTANTINOVSKY, KWOK YUEN NG,

116 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

spread to ensure it is not too narrow compared with the

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 117

Source: Barclays Research.

118 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

Investors are concerned not only with a

Source: Barclays Research.

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 119

Source: Barclays Research.

120 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

Source: Barclays Research.

Another important question concerns the stability Cross-Market Liquidity Comparisons

Source: Barclays Research.

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 121

Source: Barclays Research.

while the other consists mainly of long-duration, sea-

122 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

Source: Barclays Research.

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 123

124 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

Source: Barclays Research.

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 125

To illustrate, we apply both a traditional VaR Benchmark Replication

Source: Barclays Research.

126 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

kinds of speculation about liquidity consequences. The

(30 bps versus 130 bps).

Source: Barclays Research.

Source: Federal Reserve Bank of New York, Barclays.

SUMMER 2016 THE JOURNAL OF PORTFOLIO M ANAGEMENT 127

Source: Barclays Research. ENDNOTES

128 M EASURING BOND -LEVEL LIQUIDITY SUMMER 2016

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