Bond Market Liquidity

Liquidity in the financial markets refers to the ease of converting an asset into cash through a sale and the relative ease of buying assets. Assets quickly and easily converted at their intrinsic value are considered liquid. On the other hand, if a transaction is time-consuming, complicated, or requires price concessions, the asset is deemed illiquid.

Several factors can lead to illiquidity in the bond market, including:

• Large number of issues from a single issuer.
• Infrequently traded bonds.
• Bonds with diverse features and options.
• Bonds with varying maturities and credit qualities.
• Trading in over-the-counter (OTC) markets.

Liquidity Among Bond Sectors

• On-the-run high-quality sovereign debt is typically one of the most liquid bond markets. These bonds are recently issued with large face values and are commonly traded on public exchanges. However, as the original issue date ages, liquidity may decline. Nevertheless, these bonds are highly liquid and visible, often as benchmarks for pricing other bonds or collateral in the repurchase agreement market.
• Corporate bonds, on the other hand, are generally less liquid due to their diverse nature. They come in various shapes and sizes. Lower-quality corporate bonds, in particular, have lower demand and are less liquid than high-quality corporate bonds. Additionally, larger face-value corporate bonds tend to be more liquid than smaller ones.

Effects of Liquidity on Fixed Income Portfolio Management

• Pricing data can be challenging in fixed-income markets due to their over-the-counter nature. Transaction data is often hard to find, making bond matrix pricing a valuable tool for valuing fixed-income securities. Matrix pricing relies on recording details of recent transactions in similar bonds and using the average yield to maturity (YTM) to calculate the value of new bonds.
• Portfolio construction is critical in determining the relative attractiveness of bonds with differing liquidity. Buy-and-hold investors, who do not need liquidity and have no plans to sell bonds, can capture an illiquidity premium. On the other hand, more liquid markets are preferred by investors who plan on frequent trading, which often characterizes active investors.
• In a dealer-dominated market, illiquid bonds are sold with wider bid-ask spreads. This is done to compensate the dealer for the risk of moving their illiquid inventory.

Alternatives to Direct Investment in Bonds

Instead of directly investing in illiquid bonds, investors often turn to derivatives such as bond futures and interest rate swaps. Additionally, there are numerous ETFs available to track bond market performance. Professional traders conduct arbitrage trades on the index and its underlying bond instruments to keep the ETF's net asset value close to the intrinsic value of the index constituents.

• ETFs and mutual funds offer alternatives to individual bond transactions, with higher liquidity than the underlying bonds. Mutual funds pool investments, and their shares represent ownership in a portfolio of assets. Open-end mutual funds allow daily share redemptions at their net asset value (NAV), making it easier to exit illiquid positions. Smaller investors often choose bond mutual funds for economies of scale benefits, as replicating broad bond indices or managing diversified portfolios individually can require substantial investments.

  Although bond mutual funds provide increased diversification across fixed-income markets, they outline investment objectives and fees but disclose security holdings only retroactively. Unlike individual bonds, mutual funds lack maturity dates and continually buy and sell bonds to track index performance, leading to varying monthly interest payments.

  Exchange-traded funds (ETFs) share characteristics with mutual funds but offer more tradability due to their ability to be bought or sold throughout the trading day, providing greater bond liquidity than mutual funds.

• Exchange-traded derivatives, such as futures and options on futures, offer exposure to underlying bonds. These financial instruments are traded on organized exchanges, featuring standardized terms, documentation, and pricing. Additionally, exchange-traded products encompass interest-rate instruments and options related to interest-rate exchange-traded funds (ETFs).

• OTC derivatives, notably interest rate swaps, are highly utilized globally. These derivatives involve customized agreements referencing a market price or index between two parties. While some interest rate swaps are liquid and involve competitive quotes from multiple dealers, fixed-income portfolio managers also employ inflation, total return, and credit swaps to adjust their portfolio risk. The over-the-counter nature of swaps allows for tailoring to meet specific investor requirements.

Question

Which of the following bond market sectors is the most liquid?

1. Off-the-run, low-quality government debt.
2. On-the-run high-quality government debt.
3. Corporate debt.

Solution

The correct answer is B.

On-the-run high-quality government debt has the following features:

• Among the most liquid of all bond markets.
• These are recently issued bonds with large face values.
• Commonly traded on public exchanges with narrow bid-ask spreads.

A is incorrect. Off-the-run refers to older or less actively traded government bonds that are not the most recently issued (on-the-run). Low-quality government debt typically refers to bonds with lower credit ratings. Both of these characteristics tend to reduce liquidity. Investors often prefer more recent, actively traded, and higher-quality government debt for liquidity and ease of trading.

C is incorrect. The liquidity of corporate debt can vary widely. Some highly rated and widely traded corporate bonds, especially those of large, well-established companies, can be pretty liquid. However, corporate bond liquidity can be lower for bonds from smaller or less well-known issuers or those with lower credit ratings. Therefore, it's not inherently more liquid than on-the-run high-quality government debt, specifically known for its liquidity. On the other hand, corporate debt:

• They are less liquid as they come in all shapes and sizes.
• Trade infrequently in small quantities.
• They have wider bid-ask spreads and less liquid than on-the-run, high-quality government debt.

Portfolio Construction: Learning Module 2: Overview of Fixed-Income Portfolio Management; Los 2(c) Describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management