Secondary Markets for Bonds

Secondary markets are “aftermarkets” where existing securities are traded among investors. The major players in these markets are large institutional investors and central banks. Below are the two main classifications of secondary markets.

• Organized exchanges where buyers and sellers transact according to stipulated exchange rules. These days, most traders do not physically meet to buy and sell securities. Instead, all trading takes place virtually.
• Over-the-counter (OTC) markets in which buy and sell orders are matched via a broker-dealer network. The vast majority of bonds are traded in OTC markets since they are not listed on formal exchanges.

Bid and Ask Spread

The Bid-offer spread (or bid-ask spread) is the amount by which the ask price exceeds the bid price for an asset. It is usually considered as an indicator of liquidity. A reasonable spread is generally 10-12 bps, whereas an illiquid asset may trade at a spread beyond 50 bps. When there is no bid or offer price, the bond is said to be completely illiquid.

Settlement of Bonds

Settlement occurs after the trade takes place. The bonds are passed to the buyer, and the seller receives payment. Secondary market settlements for government or quasi-government bonds are usually realized on a cash basis or T+1 basis (one day after the trade). In contrast, corporate bonds usually settle on a T+2 or T+3 basis (2 or 3 days after the trade).

Question

ABX Mutual funds buys a large amount of 5-year U.S. T-Notes from a competitor fund. The trade will usually settle:

1. On the trade date plus 1 day.
2. On the trade date plus 7 days.
3. On the trade date, plus 2 or 3 days.

Solution

The correct answer is A.

Secondary market settlement for government or quasi-government bonds usually occurs on a cash or T+1 basis.

B and C are incorrect as corporate bonds usually settle on a T+2 or T+3 basis.