Debt issuance by corporations has grown rapidly in recent years, as low interest rates have made borrowing attractive and investors’ demand for yield has resulted in billions of dollars flowing into bond funds. At the same time, inventories held by bond brokers have fallen to the lowest levels in recent history. New regulations, enacted after the financial crisis in 2008, require banks and brokerage firms to hold more capital against bonds they own. This has had the unintended consequence of decreasing liquidity in the bond markets. The concern is that if the Fed decides to increase interest rates and investors rush to exit bonds, the lack of liquidity could cause significant disruptions and big price declines in the bond market.

What is liquidity? There are several ways to measure liquidity, but in general, liquidity is the ability to buy or sell a security quickly at a given price. Less liquidity can lead to sharper moves in prices.

Liquidity in the primary markets, where companies like Apple and Microsoft can sell billions of dollars of debt in a single day, has covered up the real problem in the secondary market. The secondary market is where bonds change hands between investors. In contrast to the stock market, the bond market does not have an exchange (e.g., the NYSE) where bonds are bought and sold and prices are clearly visible. If investors want to sell bonds, they need to contact a broker who searches for potential buyers. If a buyer can’t be found, the broker’s trading desk can step in, buy the bonds, and hold them as part of broker inventory. This helps provide liquidity for the market and minimizes wide price swings.

The changes in banking regulations provide disincentive for financial firms to hold a large bond inventory because of the increase in capital required on their balance sheets. The good news is that this increase in capital has made banks and brokerage firms more solvent and better prepared to withstand the next economic crisis. The downside is that this requirement has forced many firms to shrink their bond inventories because it is not worth the risk or the cost of holding bonds. Thus this has reduced an important intermediary in the secondary market.

We recommend holding some cash or cash equivalents like short-term US Treasury Notes as one way to protect portfolios from the current lack of liquidity. Treasuries are generally one of the most liquid securities in the bond market. While buying Treasuries today may hurt performance in the short term (due to very low yields), it will provide a safe haven in times of economic stress.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.