The Relation between Government Bonds Liquidity and Yield

Transcription

1 Capital Markets The Relation between Government Bonds Liquidity and Yield Pil-kyu Kim, Senior Research Fellow* In this article, I analyze the microstructure of government bonds liquidity using trading data of the secondary government bonds market. According to the result, Korea s secondary KTB market recently experienced growth in trading volume, trading frequency, and turnover. The analysis on trading frequency and turnover by bond type over time reveals that both 3-year and 5-year KTBs are traded actively for the first year of issuance, showing the on-the-run effect. On the other hand, the on-the-run effect in KTBs with 10-year or longer maturity emerged only in Before then, there was no on-the-run effect for those issues. In addition, the result of the panel regression analysis on the impact of liquidity on yield reveals that the yield to maturity of highly liquid bonds has a statistically significant negative impact. This supports existing study results where highly liquid bonds are traded at higher prices. The result of this study provides an implication: To sustain the current growth of Korea s bond market, more efforts should be made to foster the secondary market for long-term bonds. Although trading of long-term bonds has revitalized since 2009 due to the increased demand for long-term bonds, the trading frequency and turnover of long-term bonds are still lower than those of 3-year and 5-year issues. Therefore, policy support should be provided to expand demand for long-term bonds and facilitate the secondary market for them. * All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as the Korea Capital Market Institute s official position. Tel: , pkkim@kcmi.re.kr Vol. 4, No. 3

2 The Relation between Government Bonds Liquidity and Yield I. Introduction Korea s government bond market has achieved qualitative and quantitative growth thanks to increased issuance, wider investor pools with diverse demand and preference, and policy efforts for institutional improvements. In terms of market structure, Korea s secondary market for government bonds shows a different course of development compared to other nations. While the OTC market is the main driver for secondary market development, Korea has two competing pillars of development: the Inter-dealer Market within the Korea Exchange (IDM), and the OTC market. One of the primary measures of government bond market activities is liquidity in the secondary market. Bonds are traded in many different types because each bond, although issued individually by one issuer, is different depending on when it is issued and under what conditions. Therefore, the market liquidity of bonds is distinguished from that of stocks. In theory, a highly liquid bond in the market means that the bond can be traded at a reasonable price at the right time. This study analyzes the microstructure of government bond liquidity by using Korea s government bond trading data. Despite the qualitative and quantitative growth of the Korean government bond market, no sufficient analyses have been conducted on the microstructure of the secondary market. Hereupon, in this study, I use individual trading data from both the IDM and OTC secondary market for government bonds to analyze liquidity of the markets and the impact on bond prices. Specifically, I examine how a bond s trading frequency and turnover changes over time after issuance in the IDM and OTC market. I also analyze how long bonds with different maturities remain as on-the-run issues, and the characteristics of liquidity in the IDM and OTC market. Last, I explore how liquidity and other characteristics of government bonds affect prices to find out the impact of bond liquidity on price efficiency. 7

3 Capital Market PERSPECTIVE II. Current Status of Government Bond Market 1. Primary market Korea s government bond market continues to grow as it has more issues and diverse market participants than before. Korea Treasury Bond (KTB) issues increased until 2005, but began to decrease after But since 2009, fiscal demand increased in the aftermath of the global financial crisis and KTB issues rose dramatically. New issues slowed slightly in 2010 compared to the previous year, but began to increase in As government bond issues increased and the proportion of long-term bonds rose, KTB outstanding continued to go up and reached KRW 340 trillion as of the end of Figure 1. KTB issues and outstanding Source: Ministry of Strategy and Finance 2. Secondary market The trading volume in the secondary market for government bonds has steadily risen. In the IDM, all types of bonds saw their trading volumes increase, especially in The steep growth in 2011 was attributable to the government s phased policies to Vol. 4, No. 3

4 The Relation between Government Bonds Liquidity and Yield boost the market and proactive market making by primary dealers. Another reason is increased preference for safe assets. This pushed up demand for KTB and helped boost the secondary KTB market. Figure 2. KTB trading volume by year Source: Ministry of Strategy and Finance Dramatic growth in trading volume was seen in 3-year, 5-year, and 10-year KTBs. Especially in 2011, demand for long-term bonds rose and the trading volume of 5-year and 10-year KTBs increased 115% and 128%, respectively. Figure 3. KTB trading volume by maturity Source: Ministry of Strategy and Finance 9

5 Capital Market PERSPECTIVE In the OTC market, the trading volume fell slightly in 2011 compared to 2010 because trading in the IDM grew significantly. By bond type, the trading volume of 3-year KTB increased rapidly in 2009, but since then, that of the 3-year on-the-run issue has fallen. As for 3-year and 10-year KTBs, the trading volume of on-the-run issues has increased since This is due to active trading activities around 5-year and 10-year KTBs in year on-the-run Table 1. KTB trading in the OTC market by type 3-year off-the-run 5-year on-the-run 5-year off-the-run 10-year on-the-run 10-year off-the-run (Unit: KRW trillion) , , , , , ,969.5 Source: Ministry of Strategy and Finance Total III. Analysis on Liquidity of the Government Bond Market 1. Analysis measure and method Bond market liquidity is defined by various indicators, and the concept of liquidity is loosely defined. O'Hara (1995) defines a highly liquid market as one where transactions are executed without high transaction costs. Generally, a highly liquid market means a marketplace where traders can buy or sell a bond at the right time and price without trading costs. Bonds are more diverse than equity types, and not all types of bonds are traded every day in today s markets. Therefore, liquidity in a bond market is distinguished from that in the equity market. Bond liquidity is computed by various measures: trading volume, trading frequency, Vol. 4, No. 3

6 The Relation between Government Bonds Liquidity and Yield turnover, quote spread, quote size, trading size, and spread of on-the-run issues. Liquidity measures in general have a high correlation with each other, except for some whose correlation is limited to certain periods and conditions. Amihud and Mendelson (1991) show that liquidity of securities impacts prices. They argue that highly liquid securities are more expensive than illiquid securities. It is important to note that there are discrepancies in Korea s bond market data due to the structural differences between the IDM and OTC market. While the IDM adopts a competitive bidding process allowing market participants to observe quote spreads and closing prices, the OTC market uses negotiated bidding where measuring quote spreads is difficult. The trading volume is also different. In the IDM, it is possible to see closing prices and trading sizes immediately, but the OTC market offers separate trading volume data for selling and buying. Last, the IDM market centers on KTBs while more diversified types of bonds are traded in the OTC market. This study is designed to compare liquidity between the IDM and OTC market and to analyze each market s characteristics. Therefore, it uses variables including trading volume, trading frequency, and turnover. Here, trading volume refers to the trading value reflecting each bond s price. Trading frequency in this study means the number of transactions per day. Last, turnover is measured by dividing the trading value by the total amount of issuance for a certain period. The data used here comes from the individual bond trading data in the IDM and OTC market provided by KIS Pricing. Information related to IDM transactions is disclosed by the Korea Exchange, while OTC transactions are reported to the Korea Financial Investment Association within 15 minutes of a transaction. The bonds analyzed here are KTB coupon bonds issued after 2004 and exclude KTBi and Separate Trading of Registered Interest and Principal of Securities (STRIPs). Only the IDM and OTC market are included in the analysis. As the OTC market discloses separate data for buying and selling transactions, this study uses the data for buying transactions only. 11

7 Capital Market PERSPECTIVE 2. Status of liquidity Between 2005 and 2011, the daily average KTB trading value in the OTC market stood at KRW 4.55 trillion, while that in the IDM was KRW 1.50 trillion. As for the trading value in the OTC market, a slight decrease was seen from 2006 to 2007, but a steady increase was observed between 2007 and In 2011, however, the trading value in the IDM soared while that in the OTC market plunged compared to the previous year. Since 2007, the IDM has steadily grown. The trading value temporarily fell in 2010 when the government scrapped the policy that mandated primary dealers to trade on-the-run KTBs in the IDM. But it quickly recovered and greatly increased from 2011, with the daily average trading value reaching KRW 2.48 trillion. Table 2. Average daily trading value of KTB (Unit: KRW 100 million) Average OTC market 34,617 31,582 30,579 34,965 58,920 76,296 50,964 45,534 IDM 13,492 10,818 12,656 12,831 17,130 13,770 24,784 15,078 Total 48,109 42,400 43,235 47,795 76,051 90,067 75,748 60,612 Figure 4. Average daily trading value of KTB Vol. 4, No. 3

8 The Relation between Government Bonds Liquidity and Yield The combined daily average trading frequency in the IDM and OTC market fell until 2007, but began to increase in 2008 and recorded 1,675 transactions in From 2005 to 2011, the average KTB trading frequency in the OTC market stood at 472 transactions, which was higher than 348 transactions in the IDM. In the OTC market, the trading frequency fell until 2007, but started to rise from However, it began to fall again in Notably, the trading frequency in the IDM picked up significantly while that in the OTC market went down from In the IDM, the daily average trading frequency decreased in 2006, but since then, a steady growth has been observed. Especially since 2010, remarkable growth has been achieved and the figure reached 1,178 transactions in The growth stems from the change in the market rule, where the minimum trading unit in the IDM was reduced from KRW 10 billion to KRW 1 billion. Table 3. Daily average trading frequency of KTB (Unit: number of transactions) Average OTC market IDM , Total ,225 1, Figure 5. Daily average trading frequency of KTB Trading frequency (OTC market) Trading frequency (IDM) 13

9 Capital Market PERSPECTIVE 3. Analysis on on-the-run issues From 2004 to 2010, the monthly trading frequency of 3-year KTBs rose for the first five months after issuance ( on-the-run effect ), and since then became off-the-run. Especially, it plunged one year after issuance. KTBs issued from 2004 to 2006 and from 2007 to 2008 showed a similar pattern while those issued between 2009 and 2010 had a much larger trading frequency for the first five months. Although 5-year KTBs showed a pattern similar to 3-year KTBs, the trading frequency while the issue was on-the-run was slightly less than the 3-year KTBs. The on-the-run effect was barely observed in 10-year KTBs issued between 2004 and 2006, and between 2007 and 2009, while trading of KTBs issued between 2009 and 2010 greatly increased for the first 10 months of issuance and then plunged one year after issuance. A similar pattern was found in 20-year KTBs. The issues between 2004 and 2006 and between 2007 and 2008 did not show the on-the-run effect while trading of those issued between 2009 and 2010 picked up gradually for the first 10 months and then suddenly fell. To sum up, the 10-year and 20-year KTBs issued after 2009 showed the on-the-run effect presumably because of increasing demand for long-term government bonds and the gradual development of the secondary market Vol. 4, No. 3

10 The Relation between Government Bonds Liquidity and Yield Figure 6. Trading frequency of KTBs by maturity (3-year KTBs) (5-year KTBs) (10-year KTBs) (20-year KTBs) In an analysis of KTB turnover by maturity, the 3-year KTB showed the highest turnover. The 3-year and 5-year KTBs had the highest turnover 5 months after issuance and since then it slowly fell. It abruptly plunged one year after issuance. For 10-year KTBs, the issues between 2004 and 2006 and between 2007 and 2008 had a low turnover at the beginning. But the turnover of those issued from 2009 and 2010 was high for the first year of issuance. It is estimated that this comes from the demand-supply imbalance because the 10-year KTB was issued only once during 2009 to On the other hand, 20-year KTBs issued between 2004 and 2006 and between 2007 and 2008 were traded slowly at the beginning. But trading of those issued between 2009 and 2010 was active and it increased gradually during the first year of issuance. 15

11 Capital Market PERSPECTIVE Figure 7. Monthly turnover of KTBs by maturity (3-year KTBs) (5-year KTBs) (10-year KTBs) (20-year KTBs) As shown above, Korea s secondary market for KTBs had the on-the-run effect that centered on 3-year and 5-year KTBs. Since 2009, however, demand for long-term bonds has soared, and The analysis on the liquidity of government the on-the-run effect has been expanded to 10-year bonds revealed that the and 20-year KTBs. If the appetite for long-term bonds 3-year and 5-year KTBs continues in the future, the on-the-run effect is likely to showed the on-therun effect, which has be even more evident in other long-term issues. expanded to some longterm issues since Vol. 4, No. 3

12 The Relation between Government Bonds Liquidity and Yield IV. Analysis on the Impact of Liquidity on Government Bond Prices 1. Method of analysis Existing literature shows that bond market liquidity affects bond prices. In order to confirm whether this phenomenon can be applied to Korea s KTB market, I use a model that controls other price-affecting factors, including the term structure and size of issue. Using this model, I conduct a regression analysis on the impact of KTB liquidity on bond prices. In general, bond prices are affected by their term structure, issue size, market structure, and others. Along with those price-affecting factors, this study uses the period after issuance as another liquidity variable for a panel analysis on how bond liquidity affects prices. The dependent variable of this model is the value (in bps) obtained by deducting the average mark-to-market yield of a 3-year KTB from the intraday average yield-tomaturity of each bond. Independent variables include the remaining months to maturity to control the term structure, and the issue size is controlled by the log-transformation of the issue size. Another independent variable, the log-transformation of the KTB trading volume on a specific trading day, is used to control the size of trading. Last, the on-the-run dummy variable, which indicates whether a bond is less than 12 months old and thus still an on-the-run issue, is used as an independent variable to explain bond liquidity. Hereupon, each variable refers to the following. (1) yield spread: the spread of the average yield-to-maturity of each bond 17

13 Capital Market PERSPECTIVE travol: the log transformation of the trading volume mature: the remaining months to maturity size: the log transformation of each bond issue size ontherundum: the on-the-run dummy variable As the model uses daily data for each bond, the daily fixed-effect panel model is used for this analysis. 2. Result According to the result, the on-the-run dummy variable used as a liquidity indicator here has a significant negative value. The bond yield, with all other variables in control, turns out to be low while the issue is on-the-run. This implies that highly liquid bonds have higher bond prices compared to other bonds, supporting the existing research results where bonds are traded at lower prices when liquidity becomes low. In addition, according to the sample analysis for the issues for the Period 1 (from 2004 to 2008) and the Period 2 (from 2009 to 2011), the on-the-run dummy has a significant negative value for both periods. The on-the-run dummy coefficient for Period 1 issues is smaller than that for Period 2 issues. This may have stemmed from the conversion offer program and the participation of foreign investors during Period 2. Accordingly, demand for not only on-the-run issues, but also off-the-run issues picked up, making the price discount of off-the-run issues look smaller Vol. 4, No. 3

14 The Relation between Government Bonds Liquidity and Yield travol mature size ontherundum Table 4. Results of the panel regression analysis Overall period Period 1 (2004~2008) Period 2 (2009~2011) (3.32) ** (5.04) *** (-6.18) *** (72.60) *** (36.79) *** (125.38) *** (0.52) (0.00) (2.87) ** (-11.47) *** (-15.49) *** (-5.83) *** _cons (-0.56) (-16.10) *** (-2.99) ** # of obs #of groups R-sq F Notes: 1) Analysis model: 2) Dependent variable: yield spread (the spread of the average yield-to-maturity of each bond) 3) Independent variables: travol (the log transformation of the trading volume), mature (the remaining months to maturity), size (the log transformation of each bond issue size), ontherundum (the on-therun dummy variable) 4) The level of statistical significance is 1% for ***, and 5% for **. V. Conclusion and Implications The analysis on the microstructure of the secondary market reveals that the center of Korea s secondary market, which used to be short-term KTBs, has expanded to long-term KTBs. Now, long-term KTBs proliferate in the market and their liquidity has improved dramatically since Before then, even on-the-run KTBs were traded very slowly. Such a result is presumably from the expansion of investor pools, including more foreign investors, and greater market efficiency. Moreover, the panel regression analysis on the According to the panel regression analysis on factors affecting the bond yield spread, the liquidity-related variable imposes a statistically significant impact. This well supports the existing studies where highly liquid bonds are traded at relatively higher prices. 19

15 Capital Market PERSPECTIVE impact of liquidity on bond yield proves that the liquidity-related variable has a statistically significant negative impact on bond yield spreads. Such a result is consistent with existing study results, which show that the price of highly liquid bonds is higher than that of less liquid bonds. As demonstrated in this study, Korea s secondary market for KTBs has grown in terms of quantity and quality thanks to wider investor pools and the policy efforts to increase issuance and enhance market efficiency. In order to sustain the current growth, more efforts are necessary to facilitate the In order to sustain the current bond market secondary market, especially focusing on long-term development, multifaceted policy support bonds. Although trading of long-term bonds has been active since demand for long-term bonds increased in should be provided to expand demand for 2009, the trading frequency and turnover of long-term long-term bonds and bonds are still lower than those of 3-year and 5-year facilitate the secondary issues. Therefore, multi-faceted policy support should market for long-term be provided to expand demand for long-term bonds and bonds. facilitate the secondary market for long-term bonds Vol. 4, No. 3

16 The Relation between Government Bonds Liquidity and Yield References Amihud, Y., Mendelson, H., 1991, Liquidity, maturity, and the yields on U.S. treasury securities, Journal of Finance 46, no 4, Anderson, S., Lavoie, S., 2004, The evolution of liquidity in the market for government of Canada bonds, Bank of Canada Review, Summer. Diaz, A., Merrick Jr., J.J., Navarro, E., 2006, Spanish treasury bond market liquidity and volatility pre- and post-european Monetary Union, Journal of Banking & Finance 30, Fleming, M.J., 2003, Measuring treasury market liquidity, FRBNY Economic Policy Review, September, Graveline, J.J., McBrady, M.R., 2011, Who makes on-the-run Treasury special?, Journal of Financial Intermediation 20, O'Hara, M., 1995, Market Microstructure: A Survey, Cambridge: Blackwell. 21