Liquidity risk is a consideration in any trading activity, including bond trading. While highly traded securities like stocks, major indexes, and currency pairs generally have minimal liquidity risk due to the large number of participants, there is still a degree of liquidity risk present, especially in extremely volatile markets.
Market makers play a crucial role in maintaining tight bid-ask spreads, ensuring liquidity in the market. However, during periods of high volatility, market makers may become more cautious, potentially leading to wider spreads and increased trading costs.
In some cases, particularly with less liquid instruments, it may be challenging to trade at certain times, or the cost of trading may be significantly higher. This is more common in over-the-counter products where the number of market participants is limited and doesn’t include the general public.
Liquidity is influenced by both trading volume and the number of market participants. As the number of participants decreases, liquidity risk becomes more pronounced. Consequently, when trading in less liquid markets, the liquidity risk is higher and needs to be carefully considered. Traders should account for liquidity risk by demanding additional benefits from the trade to justify the potential impact on their results.
It’s important to note that exchange-traded securities generally have higher liquidity and are less prone to liquidity issues compared to over-the-counter products with limited market participants.
Bonds and Liquidity Risk
While individual investors can place orders through dealers, the majority of bond trading occurs between these institutional players.
The liquidity of over-the-counter traded securities, including bonds, relies not only on the supply and demand in the market but also on the willingness of dealers to participate and maintain inventory. Unlike exchange-traded securities, where orders are matched directly on the market, there can be a time lag in over-the-counter trades due to the involvement of dealers.
Bonds, like stocks, are traded on secondary markets, and the liquidity of a bond issue depends on the portion of the total bond supply available for trading, known as the float. Bonds that are held by long-term investors and not actively traded do not contribute to the overall liquidity of the issue.
The impact of holding preferences varies across different bonds, and highly traded bonds such as U.S. treasuries typically have large floats and sufficient dealer participation, resulting in ample liquidity. However, bond liquidity is closely tied to dealer inventory. When dealer inventories become lower, it can indeed affect the liquidity of the market. If there is a shortage of available inventory or dealers are unwilling to add to their inventory, liquidity may decrease, making it more difficult to execute trades.
While the overall bond market is sizable and typically maintains adequate liquidity, concerns about liquidity are more relevant for thinly traded corporate bonds. Lower floats can make these bonds more susceptible to liquidity losses when there are significant imbalances in supply and demand.
Investors should be aware of potential liquidity risks when trading in less liquid bond markets, as sudden changes in market dynamics can impact liquidity and affect the ease of placing trades.
It’s Really About the Spreads
The spread, which refers to the difference between the bid and ask prices of a financial instrument, plays a crucial role in trading, including bond trading. Thinly traded securities often have larger spreads, as reduced market activity leads to less liquidity.
Market makers or dealers are willing to assume certain risks to facilitate trading and aim to profit from the spread. If there is an opportunity to make money by narrowing the spread, market participants, including traders, may attempt to exploit it. However, in today’s highly automated and efficient trading environment, individual traders face competition from sophisticated market makers and institutions.
Exchanges have become more efficient over time, contributing to tighter spreads and increased liquidity. Traders can benefit from these improvements in efficiency, as they compete with automated trading programs on the exchanges.
In the case of dealer-traded instruments such as bonds in over-the-counter markets, individual traders do not have the same advantage of stepping in between the spread to profit by narrowing it as they can on exchanges. The size of the spread in these markets is determined by dealers, and it may not be as efficient as exchange trading because the participants are not brought together in a centralized location.
Although dealers are not isolated, there is still information flow among them that helps keep prices and spreads in check to some extent. If one dealer offers a wider spread than another, business may flow toward the dealer with the lower cost, albeit not as seamlessly as in an exchange where this process would be automated.
The trading of large quantities of bonds is not as efficient as the trading of other instruments such as stocks, foreign exchange, or futures. The comparison with the spreads of precious metals like gold and gold futures highlights the cost of carry associated with physical assets versus derivatives. While physical gold has higher carrying costs, bond trading also involves costs of carry, which are factored into spreads to some extent.
Derivatives markets, like futures, tend to be more efficient because there is no physical exchange of the underlying asset. In the case of gold futures, for example, only a small percentage of participants intend to take delivery of the actual metal. The absence of physical exchange reduces costs and allows for transactions to occur electronically, making derivatives markets more streamlined.
How Much Should Bond Liquidity Be a Concern?
Individual investors often invest in bonds through bond funds rather than buying them directly on the over-the-counter market. This is particularly true in the current environment where diversification is highly valued. Buying individual bonds can be cost-prohibitive for most individual investors due to high trade minimums, making it difficult to achieve adequate diversification unless one has a significant amount of money to invest.
When investing in bond funds, individual investors are less concerned about bond liquidity as it is the fund’s responsibility to manage liquidity risk. However, bond funds may still be exposed to liquidity risk, especially if they invest in bonds with varying levels of liquidity, such as corporate bonds.
Individual investors who choose to invest directly in bonds often focus on heavily traded bonds, especially those issued by the U.S. government, which are highly liquid due to their popularity.
However, if individuals consider investing in less liquid bonds, particularly if they are not held to maturity, some liquidity risk may be present and should be taken into account.
| Benefits of Bonds | Characteristics of Bonds |
| Risks of Bonds | Bonds as Investments |
| Bonds for Diversification | Bonds vs. Stocks |
| Corporate vs. Government Bonds | Trading Bonds |
| Bonds and Liquidity | Bond Funds |
Bonds with higher liquidity risk tend to offer higher yields, as investors demand compensation for the additional risk, including liquidity risk. In theory, greater liquidity risk should be priced into these bonds.
The concern over liquidity is more relevant for traders than for long-term investors. For traders, the size of the spread between the bid and ask prices is crucial, as it affects the profitability of their trades. Thinly traded bonds may have wider spreads, requiring larger price movements to achieve similar profitability compared to more liquid bonds. Additionally, less liquid bonds may experience greater price fluctuations due to lower demand.
While bond traders may focus more on liquidity, individual investors who hold bonds for longer periods of time are generally less concerned about liquidity risk.
Given that the primary objectives of holding bonds are generating income and hedging, there is generally little reason to buy less liquid bonds. Diversification in bond holdings is typically intended to reduce risk, so purchasing riskier and less liquid bonds may not align with this goal. It is more sensible to invest in liquid bonds, and if one wishes to balance stability with more speculative investments, there are other options available beyond bonds that can provide the desired level of diversification without incurring excessive liquidity risk.
