How much importance is given to bond liquidity in investment decisions?
One out of the key considerations investors should pay particular notice to when making investment decisions is to ascertain how liquid an instrument is, both at the time of purchase as well as at the time of divestiture. Equities, bonds, currencies and collective investment schemes (investment funds) vary in degrees of liquidity, but also within the same asset class, liquidity between bonds of different credit ratings for example varies too.
Both the equities and foreign currency (the FX market) are amongst the most liquid asset classes around, however the same cannot be said for the bond market given the infinite amount of bonds in issuance and differing bond issuance volumes. At times of low volatility, when markets are trading sideways, it is by far easier to trade bonds, both buying and selling, than at times of either a market rally or market correction.
When spreads are tightening, traders and investors will be reluctant to ‘let go’ of the bonds they hold so what they do is widen the bid-offer spread (the difference between the market selling and buying prices) in an attempt to take advantage of market sentiment. So whilst it could still be possible to execute a trade, investors might not be paying more than they really should be paying. On the flipside, when the market is selling off and supply increases, investors are practically at the mercy of the market makers and their interest, if at all, in buying bonds in a weak market.
Given the fact that the large majority of international bonds are bought and sold Over-the-Counter (OTC), liquidity in a bond (let’s not forget that the bond universe much larger than the equity universe) depends on the number of market participants willing to make a market (buy and sell) in a particular bond.
In the international bond market for example, we can be faced with a situation where we have got 20 market makers in a high grade bond who would be essentially competing with one another in terms of pricing. However, in the High Yield market, liquidity is inevitably thinner and we could only have merely a handful of bids (if at all) to contend with. Furthermore, bid-offer spreads (the difference between the buying price and selling price) widen even further in times of market weakness and market participants (generally large investment banks) take advantage of this by lowering their bids.
Bonds, particularly the lower rated ones (such as high yield bonds) which are generally considered to be relatively illiquid and difficult to trade) at times when markets are moving strongly in either direction, render their moves unjustifiable at times, most notably on the downside. Market depth (number of market participants and market makers), bond coverage (of the issuer by a number of investment houses), bond size, proximity to maturity, market conditions, credit rating (and financial soundness of the bond issuer) are all key considerations investors should make when contemplating investing in a bond.
More importantly, the issue of liquidity becomes more of an issue for investors, particularly the retail type (since they trade in small sizes compared to institutions), and is further exacerbated when an investor needs to close off his/her bond positions at times of market weakness due to the reliance on the presence of a market maker. Investors need to be made aware that when either things get rough (there are issues with the financial soundness of a bond issuer) or when the market is weak and selling off, the availability of a market maker to provide reliable bids is key to closing off a position.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is 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.