Bonds and Liquidity

The Importance of Liquidity

Any time that a security is traded, there is the potential for liquidity being an issue, called liquidity risk. With many securities trades, liquidity risk is reduced to the point of being meaningless, with securities that are very heavily traded.

For example, if you are trading a high volume stock, or a major index such as the S&P 500, or a high volume currency pair such as the Euro/U.S. dollar, no one worries about liquidity risk because no matter how the market conditions may change, there will always be a lot of people trading.

There still is a bit of liquidity risk even in these very heavily traded markets, and the risk usually isn’t that you’ll not be able to trade, it’s that it may cost you more to do so in extremely volatile markets.

Market makers will generally always step in to keep the bid and ask typically tight, but in times of heavy volatility, their function will take on more risk and this may become manifest in a lesser willingness to make markets as they normally do.

In other words, at certain times you may end up paying more in terms of a spread, which has the potential to impact your results somewhat. In some cases, with instruments of very low liquidity, you may not even be able to trade at all at a point in time. This isn’t something that we really see with exchange traded securities, but it can certainly happen with over the counter products, especially where the number of market participants is strictly limited and does not include the general public.

Liquidity therefore is a function of both volume and the number of market participants, and the more limited the participants are, the more impact we may see from reductions in liquidity. Therefore, the liquidity risk of these trades is higher, and even may become a fundamental concern that must be accounted for and offset by requiring further benefits of the trade over and above what we require for the trade to be desirable.

Bonds and Liquidity Risk

Bonds are traded between dealers and not by the general public, even though the public can place orders through dealers. Bonds are sold in large lots and typically are traded between financial institutions, investment banks for instance or funds.

In comparison with exchange traded securities, where investors place orders on the market directly, with over the counter securities such as bonds, liquidity will not only depend on the supply and demand in the market like is the case with exchanges, but also depends on the willingness of dealers to engage in the market and carry inventory.

The biggest difference we see here is that with exchanges, there is no real lag between demand and supply, but with over the counter traded instruments such as bonds, there can be such a lag.

Like stocks, bonds are traded on secondary markets, and a certain amount will be held by investors with a certain percentage of issues being available for trading, called the float. Bonds in particular are subject to longer term holding, for instance a lot of people buy bonds to keep them and aren’t looking to trade them, and these bonds do not contribute to the liquidity of the issue.

This is going to affect some bonds more than others, and with heavily traded bonds such as U.S. treasuries, the market is simply so huge that a large float can be maintained and dealers aren’t generally reluctant to carry large inventories.

Bond liquidity really does come down to dealer inventory though, and when inventories become lower, this can indeed affect liquidity. Liquidity is a function of inventory really, and if there is no inventory to sell or no willingness to add to inventory, liquidity will dry up and you will not be able to place your trades in the market for the bond.

The bond market is huge and we don’t really see that generally, but investors still worry somewhat about potential liquidity losses with more thinly traded corporate bonds, and not without reason. The lower the float, the more changes in the market can affect this, and if we end up seeing a significant imbalance on either the supply or demand side, we can see a loss of liquidity.

It’s Really About the Spreads

The spread, the difference between the bid an ask for an instrument, is a key element in trading, including bond trading. Thinly traded stocks, for instance, tend to have larger spreads, and these larger spreads are a result of reduced market activity due to the thinner trading.

Market makers or dealers are willing to take on certain risks to make these markets, looking to scalp certain amounts with their trades, but not willing to expose themselves to too much downside when doing so.

If there is money to be made by doing this, someone will step up and do it, as a form of market arbitrage. If, for instance, a stock has a wide spread, traders may even try to do this themselves. Exchanges have become more efficient and nowadays traders have much more difficultly doing this as they are competing with the sophisticated automated trading programs of market makers and other institutions, but this improvement in efficiency serves to add more liquidity and reduce spreads further.

With dealer traded instruments such as bonds, off exchanges, we do not have this advantage, and it’s not that an individual can step in between the spread to look to profit by tightening it the same way as you can do on exchanges. This is one of the advantages of exchanges, and one that we do not have in the bond market itself, although we do see it in the bond futures market because futures are traded on exchanges.

The size of the spread with over the counter markets is whatever the dealers choose to set it at, and as is the case with other forms of non-exchange trading, it ends up not being as efficient as exchange trading, because all of the participants are not brought together in a single place like exchanges do.

It’s not as if dealers are isolated though, and there is still a flow of information among them, keeping their prices and spreads in check somewhat. If a certain dealer offers a certain spread and another dealer offers a better one, the business will tend to flow to the lower cost dealer, although not quite in the same way as an exchange would, where this process would be automated.

Buying and selling large quantities of bonds isn’t as efficient as the trading of many other instruments, like stocks, foreign exchange, futures, and so on. A good comparison would be looking at the spreads of precious metals such as gold and comparing them with the spreads with gold futures, and while the cost of carry is much higher with the real metal, there is a cost of carry associated with dealing in bonds and this does get factored into the spreads somewhat.

This is what makes derivatives markets so much more efficient, as there is no gold held in this example by anyone, aside from those who actually want to take delivery, which is actually a small percentage of the gold futures market. Nothing changes hands and therefore there is no cost of this being added to the spread, and one can buy or sell gold futures and only have this involve changing numbers on computers between the participants.

How Much Should Bond Liquidity Be a Concern?

Individual investors don’t usually buy bonds on the over the counter market that much anyway, as most of those who invest in them generally will do so through a bond fund. This is much more the case these days with diversification being all the rage and it would take an enormous amount of money to buy bonds individually with their high trade minimums and be diversified, which is limited to very high net worth investors and institutions.

When we buy bonds in a fund, we don’t really worry about bond liquidity, although this can certainly impact the fund, especially given that they tend to invest very broadly and will invest in bonds that have various levels of liquidity risk, especially with corporate bonds.

Those individuals who do invest in bonds on their own do tend to focus a lot more on the heavily traded ones, especially those issued by the United States government, which are very liquid due to their popularity.

Should individuals be considering investing directly in less liquid bonds, unless one is certain that the bond will be held to maturity, some liquidity risk may be present and may need to be accounted for.

Bonds that have higher liquidity risk tend to be higher yielding though, and although other risks, especially default risk, is behind these higher yields, more risk of any sort, including more liquidity risk, will be priced in, or at least should be in theory.

The more likely a bond will be traded, the more of a concern this is, as the bond’s value needs to exceed the spread for the trade to start to be profitable. Bigger spreads therefore mean that your trade has to move more to end up in the same place, although more thinly traded bonds also tend to be subject to greater price fluctuations simply based upon the lower demand, where a given event will therefore tend to drive the price higher or lower than if it were more liquid.

This is why thinly traded stocks can move so much, percentage wise, and less liquid bonds are nowhere near this volatile, but there can be a bit of a difference anyway. This can both elevate the potential returns of the trade as well as the risk, and good traders generally are more concerned about risk, so liquidity to them is even more important than to investors who generally are not too concerned about bond liquidity.
Few individuals trade bonds or even contemplate this, and generally do intend to hold them for fairly long periods of time, but the shorter the time frame for bond holdings, the more liquidity needs to be a concern.

Given that the two primary objectives for holding bonds are to generate income and to hedge, there really isn’t that much of a reason to buy less liquid ones, and if we are looking to diversify our bond holdings we really need to understand that we do so to reduce risk, so buying more risky ones does not really serve this purpose, although this might look good to a neophyte investor who may delight in the thousands of different bonds his or her fund may hold.

It does make more sense to invest in more liquid bonds than less liquid ones overall, and if one wishes to balance liquid and stable bonds with more speculative investments, we don’t just have to look at bonds to do this as there are many other things we can invest in to provide all the spice we want in our portfolios and not incur excessive liquidity risk.