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Why do most bonds trade OTC?

Following the issuance of bonds on the primary market, bonds can either trade on an exchange or what is known as Over-The-Counter (OTC). In Malta, both government and corporate bonds trade on the Malta Stock Exchange (MSE) from one MSE account to another via the available brokers on the exchange, however, the international bond market is more vast, with tens of thousands of different types of bonds exchanging hand OTC.

The secondary markets, whereby both equities and bonds trade after issuance, differ according to the asset type. Foreign equities generally trade on stock exchanges, which is a centralised location whereby buyers and sellers meet, and every investor can see these orders.

Prices on buy orders are called bids, while prices on sale orders are called offers. All traders can transact at the best available price, and once executed, such trade is recorded. Stock exchanges generally encourage wide participation, promote transparency, and help create a level playing field for investors.

However, bonds generally trade OTC. Although a large number of international bonds are listed, the bulk of trading activity is seldom done on exchange but rather OTC, which means that investors engage in one-off deals with each other often through a wide network of bond dealers and brokers.

Unlike exchanges, the bids to buy and sell a particular bond are not visible by all market participants, whilst executed prices are not recorded in a structured way in the same manner as equities are.

But why do bonds trade OTC?

First and foremost, the numbers of bonds are plentiful. For example, there is only one Goldman Sachs Inc. equity but hundreds of bonds with different yields, maturities, and even currency denominations of the same company.

Secondly, the monetary value of bond trades are generally larger than equity trades. In the US, the average size of an equity trade is less than $10,000 whilst the average bond trade exceeds $500,000. This leads us to believe that the chunk of bonds are transacted by large institutional investors, such as banks, mutual funds, insurance companies or even pension funds.

Thirdly bonds trade much less frequently than equities. Equities seem to have a consistent supply of buyers and sellers in the market every day, however the same cannot be said for bonds. Bonds are generally very liquid in the few weeks after being issued but liquidity generally tends to run dry.

Therefore, as can be seen, unlike equity markets, there is rarely that continuous two-way market of buyers and sellers. Instead, liquidity is hence most importantly provided by dealers who function in two ways.

Firstly, dealers or brokers place their own capital at risk by purchasing bonds from an investor, even if they do not have another investor willing to buy those bonds. This is known as ‘buying on their own book'.

This means that they are taking the risk on themselves to eventually find a buyer to whom they can sell the bonds, at a profit. Secondly, the dealer/broker can also take an order from a client who wants to buy a quantity of a particular bond and will search for an investor who is prepared to sell the bonds.

This stage is pivotal for the liquidity of the bond market – it is important for dealers/brokers to have a wide array of counterparties with whom they can transact, thereby not only guaranteeing the best price but also the number of counterparties determines the level of liquidity.

The dealer will then seek to negotiate a price with the buyer and the seller which satisfies both parties to the transaction and which enables the dealer (the intermediary between the buyer and the seller) to make a profit from the difference between the price paid by the buyer and that received by the seller, better known as the spread.

Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

 

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