What are the limitations of the bid-askspreads used by Barclays Capital to compute the Liquidity Cost Score?

Question

What will be an ideal response?

Answer 1

Barclays Capital concedes that the LCS is not a perfect measure of liquidity. The problems associated with this measure identified by Barclays Capital are threefold
1) The quotes may not be the best market quote at the time. For example, if the spread-quote from the Barclays Capital trader is 140–165, there may be a 135-155 quote by a trader at another firm. Consequently, the "effective" bid-ask spread for a client would be 140–155.
2) The quote may be influenced by the inventory held by the trader or the outlook the trader has about the bond.
3) The quotes are indications, not necessarily two-way prices at which investors can transact.

Not all of the bonds comprising a credit index have quotes from the Barclays Capital traders. Nor are there bonds in the index that are followed closely by its traders. As a result, an adjustment to the LCS for such bonds is made. To do so, Barclays Capital partitions bonds into two groups: trader-quoted bonds (those bonds that during the month had at least two bid-ask indications) and non-quoted bonds (those bonds with no indications or only one bid-ask indication). Within each group, bonds are then further classified as benchmark bonds and non-benchmark bonds. The former are defined as high-profile bonds that are closely monitored by traders and whose bid-ask indication is likely to be close to the market's actual bid-ask spread. High-profile bonds are defined as on-the-run bond issues and bonds with high trading volume. Non-benchmark bonds are then off-the-run issues that experience low trading volume.

Barclays Capital developed a methodology for adjusting the LCS of trader-quoted bonds to obtain an LCS for non-quoted bonds. A statistical methodology is employed using the attributes found to impact bid-ask spreads to obtain an attribute-based LCS. The attributes include the sector, the option-adjusted spread, the trading volume, the amount outstanding, the seasoning or age of the bond (i.e., amount of time since issuance), and the bond's benchmark status. Once the attribute-based LCS for non-quoted bonds is obtained using the statistical methodology, it is further adjusted based on the frequency with which the particular bond was quoted in recent months.

The methodology allows Barclays Capital to cover sectors other than investment-grade and high-yield corporate credits in the U.S. and Pan-Euro credits. For example, an LCS can be obtained for U.S. Treasuries, TIPS, and fixed-rate agency mortgage-backed securities (MBS). Moreover, the methodology has been extended to include bonds not included in an index (i.e., non-index bonds).