Dealer quote depth trends and potential performance impact on indexed municipal bonds

Liquidity is one of several key factors that drive investment returns across every tradable asset, but quantifying it is particularly challenging for securities that trade very infrequently like municipal bonds. Money managers may not realize that they are already receiving a valuable barometer of liquidity through their daily bombardment of dealer quotes. Market participants are only beginning to extract some of the value from their large and often "noisy" dealer quote depth dataset. Ironically, investors have been consciously (or at least subconsciously) using quote trends to guide their decisions since the days when quotes were given over the phone, but today's advances in AI driven parsing technology enables the vast quantities of quote data to be digitized, normalized, combined with reference data, and stored for analysis in real-time.

• Dealer depth is the number of dealers quoting a bond at a specific point in time and it can provide some insight into the liquidity of a bond. We analysed monthly dealer depth trends from January 2015 to September 2017 on over 120 dealers for the entire municipal bond market and the constituents in the S&P National AMT-Free Municipal Bond Index.
• The likelihood of a bond trading in a given month increases with the number of dealers quoting the bond that month. Data indicates that a bond being quoted by two dealers was more than twice as likely to have a round lot trade occur (17%) than a bond quoted by a single dealer (7%).
• Analysis of parsed quote data shows that index bonds made up 7% of the instances when a single dealer was quoting a bond and a peak of 24% for the bonds quoted by five dealers.
• Data indicates that bond issue sizes less than $70 million had an average quote depth lower than one and average depths greater than three dealers did not appear until issue sizes exceeded $360 million.
• When comparing round lot trade count, quote depth, and time since issuance (seasoning), the data indicates five distinct depth bands, with 50% of all the round lot trades accounted for by issues with less than 1.4 years of seasoning.
• We reviewed monthly S&P credit rating transitions to assess the impact of event risk on quote depth and our analysis indicates that bonds that had experienced rating actions often had a higher than average quote depth, with every downgrade cluster having an average quote depth higher than 1 dealer.
• When clustering monthly performance by each quote depth cohort, quoted bonds modestly outperform in declining yield environments and significantly underperform when rates increase rapidly. However, the unquoted cohort typically performs better on both the top and bottom 10% each month versus the quoted bonds.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.