How Bad Were US Tariffs for the Liquidity of Corporate Bonds?

The global tariffs introduced by the US have led to a notable increase in bond trading volumes and significantly impacted the liquidity of fixed income products on both sides of the Atlantic. Utilizing the S&P liquidity model and quote data, this paper closely examines the evolution of liquidity in corporate bonds during the first 10 weeks following the tariff announcement. We also explore the relevance of different bond segments to gain further insights into the evolution of key liquidity indicators.

Evolution of Credit Spreads and Bond Liquidity Parameters

Our analysis of a sample portfolio of 71 US and 161 European corporate bonds offers a detailed examination of liquidity dynamics following the introduction of US tariffs on April 2, 2025, termed “Liberation Day” by the US president. By initiating our observation on April 1st, the day prior to the tariffs' implementation, we establish a baseline for assessing the immediate market impact. We then analyze liquidity 10 days later, when the tariff shock had significantly affected financial markets, to capture the short-term effects. Checkpoints on May 7th and June 10th provide a comprehensive view of liquidity trends as the situation evolved, particularly in relation to the US-China agreement in Geneva and the later increase of tariffs on steel and aluminium.

Given that the trade dynamics of corporate bonds are significantly influenced by credit spreads, it is essential to understand how the credit markets evolved following Liberation Day. An examination of the iTraxx and CDX indices shows that spreads widened immediately in response to the tariff shock, but after several days they began to revert to their initial levels. This enhanced activity in the corporate debt market was accompanied by higher bid-ask spreads and lower quote volumes, which made it costly for investors to liquidate bonds swiftly. However, as credit spread indices gradually began to stabilize in early May, liquidity moved substantially toward baseline levels indicating that the crunch had subsided.

Figure 1a: Evolution of bid-ask spreads (30-day average) against the backdrop of credit markets. Source: S&P Market Intelligence and Credit Index data.

Figure 1b: Evolution of available quote volume (30-day average) against the backdrop of credit markets. Source: S&P Market Intelligence and Credit Index data.

For a deeper understanding of how these dynamics affect the liquidity of our sample portfolio, it is necessary to estimate the time to liquidation and transaction costs for the underlying assets on the specified dates. For this purpose, we utilize the S&P liquidity model, which is founded on the concept of the liquidity trilemma: time, cost, and volume, where only one of these aspects can be optimized at any given moment. For instance, if a trader needs to sell a large volume of bonds quickly, they may have to accept higher liquidation costs. Conversely, if the trader is willing to wait longer, they can potentially sell the same quantity of bonds at a more favorable price. This trade-off approach recognizes that different market participants or funds may have distinct priorities. For example, while a pension fund manager probably cares more about cost over time, a hedge fund manager may sometimes need a quick exit from positions at the expense of higher cost.

Portfolio Results

Initially, we compare the evolution of the portfolio's time to liquidation with the changes in liquidation costs. Utilizing the trilemma approach, we conduct our analysis under the assumption of a 5-day horizon and a 50% liquidation threshold. The results, illustrated in Figure 2, indicate that the liquidity of the portfolio—assessed through both time and cost—experiences an initial increase followed by a sharp decline after Liberation Day. This pattern remains consistent until May 7th, when the time required for the liquidation of European and American bonds begins to diverge. Consequently, while the time to liquidation for the portfolio increases, the trading costs continue to decrease. This recovery dynamic presents a somewhat perplexing situation from a liquidity risk perspective and warrants further investigation to understand the underlying factors contributing to this behavior.

Figure 2: Average time to liquidation and average cost to liquidation for European and American corporate bonds. Cost relative to position liquidated under assumption of a 5-day horizon and 50% cap on portfolio assets.

Since the time to liquidation, in the absence of trading volume constraints, is primarily influenced by the size and number of available quotes, insights may be gleaned from examining the market depth. To explore this, we plot the time to liquidation of individual bonds against their average daily quote volume in Figure 3, aiming to elucidate the inflection point observed on May 7th. The plot reveals a leftward shift in the point cloud, indicating that quotes for less liquid bonds in Europe began to diminish. The reduction in trading activity within this portfolio segment subsequently led to an increase in liquidation time. 

Figure 3: Shift of the time to liquidation and average quote volume in the US and European bonds. The points accumulated on the x-axes represent the liquid securities.

Recognizing that less liquid bonds, as depicted in the scatter plot in Figure 3, exhibit different evolutionary patterns compared to their liquid counterparts after May 7th, we take a step back to analyze the performance of these two bond segments over the entire 10-week period. In Figure 4, we observe that the average time required to convert less liquid bonds into cash fluctuates significantly over time, while the time to liquidation for their liquid counterparts remains relatively stable. Notably, the liquidation time for less liquid securities decreased consistently until early May, which effectively reduced their liquidity risk amidst the turbulence in the debt market. In contrast, this level of variability is not evident when liquidity is assessed through the lens of trading costs. Although selling and buying illiquid bonds in April incurred substantial costs for market participants, the bid-ask spreads for liquid bonds also experienced a temporary spike. 

Figure 4: Average time to liquidation and average cost to liquidation for liquid and illiquid bond segments. Cost relative to position liquidated.

The findings for the less liquid bond segment illustrate that liquidity cannot be adequately assessed using a single metric; it must be evaluated from multiple perspectives. A thorough analysis requires comprehensive trading data and a sophisticated model to identify all potential weak points in the liquidity of a sizeable bond portfolio. A multifaceted approach ensures a more nuanced understanding of liquidity dynamics, allowing for better risk management and decision-making in varying market conditions.

 What Next?

While the economic environment is likely to remain uncertain in the coming months, a significant liquidity crunch stemming from US trade policies appears unlikely at this time. However, when considering the future evolution of the markets from a credit risk perspective, we should prepare for an increase in spread volatility during the second half of the year. The impact of US tariffs is expected to adversely affect the profitability of manufacturing companies, thereby deteriorating their solvency. Given that the ease of buying and selling corporate bonds is closely linked to volatile debt markets, one can anticipate potential liquidity issues arising from the decline in credit quality. In such a scenario, liquidity challenges may extend to other forms of corporate debt, including loans and securitized products.

To proactively identify portfolio vulnerabilities ahead of the next crisis, it is essential to develop sophisticated liquidity scenarios. In our next article, we will demonstrate how to construct what-if scenarios and configure stress parameters to assess how liquidity of various debt portfolios would hold up when market conditions take a turn for the worse.

As we continue to navigate the complexities of the financial landscape, understanding and managing Buy Side risk is more crucial than ever. We invite you to visit our website to explore our comprehensive Buy Side risk solutions designed to help you enhance your investment strategies and mitigate potential risks. Discover the tools and insights that can empower your decision-making and drive your success in today's dynamic market environment.