Liquidity risk refers to the ease and cost associated with buying and selling these instruments. The trading volumes and bid-offer costs can greatly differ across various fixed-income markets and regions.
For instance, sovereign bonds in large developed markets like the US or UK are typically highly liquid. The institutional bid-offer spreads in secondary markets for these on-the-run securities are often less than one basis point during trading hours. Conversely, smaller, off-the-run corporate bonds or structured notes, such as those from a small tech startup, may have bid-offer spreads of 10 basis points or more and may take days to execute. This is due to the fact that many outstanding bonds do not trade at all on a given trading day.
Trading in Fixed-Income Instruments
In the US corporate bond market, a single major issuer like Apple might have dozens of outstanding debt tranches of varying tenor, currency, or other feature, each separately traded and identifiable via a specific CUSIP or ISIN (International Securities Identification Number). Traditionally, individual bond issuance and trading has occurred in over-the-counter (OTC) markets rather than on an exchange. The liquidity of OTC markets depends on individual dealers, their specific portfolio and depth of inventory, and their willingness to supply liquidity at a cost.
Impact of Electronic Trading Platforms
Post the 2008-09 global financial crisis, the use of electronic trading platforms for bond trading has increased due to higher regulatory capital requirements reducing bond inventories among dealers. As of 2020, electronic trading platforms constituted less than one-third of individual corporate bond trading volume. However, trading in bond portfolios and bond ETFs has grown in importance. Transaction cost estimates in bond markets differ significantly from those in equity markets due to differences in market structure.
Price Discovery for Infrequently Traded Bonds
Price discovery for infrequently traded bonds, such as municipal bonds or corporate bonds, often begins with matrix pricing techniques. These techniques utilize bonds from similar issuers, like other municipal entities or corporations in the same industry, and actively traded government benchmarks, such as Treasury bonds, to establish a bond’s fair value.
Estimating Trading Cost
For bonds actively quoted on a request-for-quote system by individual dealers, such as corporate bonds or municipal bonds, the effective spread transaction cost statistic is used to estimate trading cost. This statistic, introduced in previous lessons, is calculated using the formulas below:
For buy orders: $$\text{Trade size} \times \left(\text{Trade price} – \frac{\text{Bid + Ask}}{2}\right)$$
For sell orders: $$\text{Trade size} \times \left(\frac{\text{Bid + Ask}}{2} – \text{Trade price}\right)$$
The effective spread is an inadequate measure of trading costs for positions that are traded in smaller orders over time, such as penny stocks, and/or whose execution affects market spreads, like large block trades.
TRACE Reporting System
The TRACE (Trade Reporting and Compliance Engine) reporting system is a separate, ex-post liquidity gauge specific to the US corporate bond market. Introduced in 2002, TRACE tracks real-time price and volume reporting for bond transactions. Portfolio managers often review recent TRACE trading activity to estimate the cost of trading a bond position.
Managing Liquidity Risk of Bond Portfolios
Active portfolio managers take several steps to manage the liquidity risk of bond portfolios due to the significant market risk involved in trading less liquid positions. These steps include:
- Favoring on-the-run government bonds or most recently issued corporate or other bonds for short-term tactical portfolio positioning.
- Reserving relatively illiquid positions for buy-and-hold strategies or strategic positioning to minimize expected return erosion due to trading costs.
- Considering liquid alternatives to individual bond trades to close portfolio gaps where active management adds little value, or to react quickly to rapidly changing markets. These alternatives include CDS and bond ETFs.
Fixed-Income ETFs
Fixed-income ETFs, or Exchange-Traded Funds, are essentially portfolios of bonds that are traded on an exchange, much like stocks. They offer a solution to the liquidity constraints of individual bonds traded Over-The-Counter (OTC) by creating and redeeming shares through a primary market that exists between the ETF sponsor and a group of institutional investors, also known as authorized participants.
Over the years, bond ETFs have seen a surge in popularity and are now available across a wide range of credit spectrums. They can be found in various markets and for different maturities. For instance, you can find bond ETFs for corporate bonds, government bonds, and even international bonds.
Characteristics of ETFs
While ETFs share similar cash flow exposures to individual bonds, they usually do not mature or experience duration drift, except for target maturity ETFs. ETF sponsors aim to match a specific index or profile, maintaining a relatively constant portfolio duration and paying variable monthly interest based on the overall portfolio.
Active credit managers often utilize ETFs to efficiently adjust their exposures in rapidly changing markets. ETFs are also used to strategically target segments of the market where individual bond selection is less critical.
Portfolio managers may employ hedging strategies like asset swaps to mitigate the benchmark risk of a portfolio position when relatively illiquid bond positions are bought or sold over extended periods.
Practice Questions
Question 1: Liquidity risk is a crucial aspect for active investors in fixed-income instruments, which refers to the ease and cost of buying and selling these instruments. The trading volumes and bid-offer costs can vary significantly across different fixed-income markets and regions. For instance, sovereign bonds in large developed markets are usually highly liquid, while smaller, off-the-run corporate bonds or structured notes may have higher bid-offer spreads and may take longer to execute. Which of the following statements is correct regarding the liquidity risk in fixed-income instruments?
- Sovereign bonds in large developed markets typically have higher bid-offer spreads than smaller, off-the-run corporate bonds.
- Trading volumes and bid-offer costs are uniform across all fixed-income markets and regions.
- Smaller, off-the-run corporate bonds or structured notes may have higher bid-offer spreads and may take longer to execute than sovereign bonds in large developed markets.
Answer: Choice C is correct.
Smaller, off-the-run corporate bonds or structured notes may have higher bid-offer spreads and may take longer to execute than sovereign bonds in large developed markets. This is because these types of bonds are less liquid than sovereign bonds in large developed markets. Liquidity risk refers to the risk that an investor may not be able to buy or sell a bond quickly without causing a significant change in its price. The bid-offer spread is a measure of liquidity risk, with a larger spread indicating higher liquidity risk. Smaller, off-the-run corporate bonds or structured notes are less frequently traded and therefore have lower liquidity, which results in higher bid-offer spreads and longer execution times. This is a key consideration for investors in fixed-income instruments, as it can impact the ease and cost of buying and selling these instruments.
Choice A is incorrect. Sovereign bonds in large developed markets typically have lower bid-offer spreads than smaller, off-the-run corporate bonds. This is because these bonds are more liquid, meaning they can be bought and sold more easily without causing a significant change in their price.
Choice B is incorrect. Trading volumes and bid-offer costs are not uniform across all fixed-income markets and regions. These factors can vary significantly depending on the type of bond, the market in which it is traded, and the overall economic conditions. For example, sovereign bonds in large developed markets typically have higher trading volumes and lower bid-offer costs than smaller, off-the-run corporate bonds or structured notes.
Question 2: The use of electronic trading platforms for bond trading has increased due to higher regulatory capital requirements reducing bond inventories among dealers after the 2008-09 global financial crisis. As of 2020, electronic trading platforms made up less than one-third of individual corporate bond trading volume. Which of the following statements is correct about the use of electronic trading platforms for bond trading?
- As of 2020, electronic trading platforms made up more than two-thirds of individual corporate bond trading volume.
- The use of electronic trading platforms for bond trading has decreased due to higher regulatory capital requirements.
- As of 2020, electronic trading platforms made up less than one-third of individual corporate bond trading volume.
Answer: Choice C is correct.
As of 2020, electronic trading platforms made up less than one-third of individual corporate bond trading volume. This statement is correct as per the information provided in the question. The use of electronic trading platforms for bond trading has indeed increased, but it still constitutes less than one-third of the total individual corporate bond trading volume. Electronic trading platforms have become more popular due to their efficiency, transparency, and the ability to execute trades quickly. However, despite these advantages, the adoption of electronic trading platforms in the bond market has been slower compared to other markets, such as equities. This is due to the unique characteristics of the bond market, including its over-the-counter nature, the large number of unique bond issues, and the lack of liquidity in many bonds.
Choice A is incorrect. As per the information provided in the question, electronic trading platforms made up less than one-third of individual corporate bond trading volume as of 2020, not more than two-thirds.
Choice B is incorrect. The use of electronic trading platforms for bond trading has not decreased due to higher regulatory capital requirements. On the contrary, these requirements have led to a reduction in bond inventories among dealers, which has in turn increased the use of electronic trading platforms.
Glossary
- Bid-Offer Spread: The difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
- Over-The-Counter (OTC) Markets: A decentralized market, without a central physical location, where market participants trade with one another through various communication modes.
- Matrix Pricing: A technique used to determine the fair value of a bond using similar bonds and government benchmarks.
- Effective Spread: A measure of trading costs calculated using the trade price and the average of the bid and ask prices.
- TRACE: Trade Reporting and Compliance Engine, a system that tracks real-time price and volume reporting for bond transactions.
- ETFs (Exchange-Traded Funds): Investment funds traded on stock exchanges, much like individual stocks.
- OTC (Over-The-Counter): Trading of securities between two parties outside of formal exchanges.
- Duration Drift: The change in the duration of a bond due to the passage of time.
- Asset Swaps: A derivative contract through which fixed and floating investments are exchanged.
Portfolio Management Pathway Volume 2: Learning Module 6: Fixed-Income Active Management: Credit Strategies.
LOS 6(d): Discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio