It is often said that the increase in the perceived default risk led to a fall in the demand for the corporate bonds. This led to the fall in their prices and hence, their interest rates rose significantly. In fact, the risk and liquidity premium rose 360 basis points from 1.85% before the crisis to 5.45% afterwards. However, can we also attribute this fall in the demand for corporate bonds to a decrease in liquidity of these assets. It seems to make sense to say that as a result of there being less buyers, the market for these corporate bonds is thus less liquid. This decreased liquidity further diminishes the attractiveness of these assets, causing the demand for them to fall even more. I am asking if such a vicious cycle exists: Increased perceived default risk, leading to decrease in number of buyers, leading to decreased liquidity, leading to further decreases in the number of buyers, and so on?
2 Answers
"...if such a...cycle exists..."---i.e. in economic language, whether liquidity and demand are endogenous to each other. Yes, of course they are. Liquidity (or illiquidity) of any asset can be viewed as an equilibrium outcome where agents confirm each other's beliefs---similar to the liquidity/illiquidity of a bank. As such it has a self-fulfilling aspect. An asset is liquid because people believe it is and therefore are willing to trade/make markets for it. This in turn leads to demand for the asset, which makes it liquid.
There are many instances during the 2007-2008 Financial Crisis that illustrate this. In the US, the Fed took positions to restore confidence in illiquid markets. The Fed eventually took no loss on those positions. Of course, the Fed also took similar actions to prevent/stop runs on financial institutions.
There are also similar examples during the current Covid-19 episode. In March 2020, liquidity of corporate bond market returned as soon as the Fed announced its corporate bond purchase program---long before it was actually implemented. When the program was eventually implemented (which the Fed must, to signal its credibility), only a small portion of planned purchase was made. Market's belief in liquidity was maintained as long as the Fed is believed to be credible. (See also here.)
Liquidity is a vague term, and it is more useful to talk about other factors that are measurable. However, the theory that a lack of liquidity alone causes investors to shy away runs against the reality that investors were very interested in real estate and private equity — both considered “illiquid” — before 2008.
Corporate bonds are always somewhat illiquid. It is also unlikely that investors would not participate in the primary market at all - which is what is needed to raise default risk - solely on the basis of wider bid/offer spreads in the secondary market (for example).
Instead, we need to look at why corporate bond markets seized up. Unlike equities, corporates are dealer markets. If the dealers are unable to finance inventory, they cannot make a two-way market - they are happy to sell, but not buy. This creates the lack of liquidity in secondary market trading.
Disruptions in the funding markets - repo, money markets, cross-currency basis swaps - are what curtailed dealer financing. Those markets were not spooked by the corporate bond market per se, rather the perceived default risk arising out of structured products, and the exposure of dealer banks to them.
This answer is arguably opinion-based (albeit from someone who was in contact with those dealer markets at the time). The key factual point to keep in mind is the market structure, and the importance of dealers being able to finance corporate bond inventory. What triggered this loss of inventory capacity could be debated, but whatever it was, this is the driving factor for liquidity.
