For large and mid-sized companies, corporate bonds are a key mechanism for raising debt finance on a large scale. The total number of corporate bond issuances nearly tripled during the financial crisis, and smaller firms are increasingly tapping these markets. But despite these robust figures, some market participants have raised concerns about the limited liquidity and vulnerability to stress of these markets, which could result in higher borrowing costs for European companies. This is why the European Commission is analysing EU corporate bond markets and reviewing the way they work, in the framework of the Capital Markets Union Action Plan.

Why are corporate bonds important?

Corporate bonds are an important source of funding for large and mid-sized companies, which can use the proceeds from bond sales to invest in growth and job creation. They offer businesses access to alternative, more diverse sources of funding, which is one of the key objectives of the Commission's flagship Capital Markets Union project.

The volume of outstanding bonds issued by euro area non-financial companies has gradually been increasing over the past 20 years, reaching over € 1.1 trillion in 2015. At EU-28 level, this figure stood at almost € 1.8 trillion in the same year.

How do corporate bond markets work…?

Companies issue new bonds and sell them to investors in the so-called primary market – in other words, markets where bonds are created and initially sold to investors. But just as importantly, on the secondary market investors can sell corporate bonds they already own (and which they may have bought in the primary market), and investors can buy corporate bonds that may no longer be available on the primary market.

Unlike trading in equities, which mainly takes place in exchanges that bring together multiple buyers and sellers, trading in corporate bonds has traditionally relied on market-makers. These are banks or broker-dealers who simultaneously provide sell and buy prices to their clients for the same bonds. If a client wants to sell a bond, the market-maker will provide a "bid" price; if a client wants to buy a bond, the market-maker will provide an "ask" price. The difference between these two prices (the so-called "bid-ask spread") represents the potential profit for a market-maker, and is meant to compensate the risk that the market-maker takes for its holding inventories of bonds.

… and how did they perform during the crisis?

Helped by historically low interest rates, the volume of European corporate bond issuances has more than doubled between 2008 and 2015. But despite record primary issuance, some market participants have raised concerns about limited liquidity in secondary markets. Liquidity refers to the ease of trading an asset, notably if it can be bought or sold in sufficient quantities, at any given time, without affecting its price significantly. Liquidity is particularly important for the efficiency and stability of secondary markets. A liquid market allows investors to adjust their portfolios, and help companies to secure lower borrowing costs when they issue bonds in the primary market.

Several factors have been identified to explain the perceived decline in corporate bond market liquidity. Among other possible reasons, some market participants have highlighted the impact of financial regulations that were put in place in response to the crisis to make the financial system more resilient, such as stricter bank prudential rules, tighter limits on hedging requirements, and a push for greater transparency. They call for careful consideration when it comes to the definition and calibration of new regulatory measures that may impact market liquidity. Other commentators, meanwhile, point rather to structural and cyclical factors to explain the retrenchment of some market makers.

Improving corporate bond markets

Following these concerns about the decline in market liquidity and efficiency, and given the lack of consensus on what is driving these developments, the Capital Markets Union Action Plan has called for a review of EU corporate bond markets and how they work. This review should focus on how market liquidity can be improved, the potential impact of regulatory reforms, market developments and voluntary standardisation of offer documentation. The Commission has launched a study on the drivers of corporate bond market liquidity and, on 26 July, organised a workshop to generate some practical insight into how the way corporate bond markets work can be improved. In addition, the Commission has recently set up an Expert Group to provide practical market expertise and input to the wider policy debate on how to improve the efficiency and resilience of corporate bond markets. In September 2017, the Expert Group will publish a report presenting its analysis and recommendations. This will serve as a basis for the European Commission's policy for this increasingly important source of funding.

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