Bond Liquidity—Factors to Consider and Questions to Ask
If you're like many investors, your portfolio contains bonds. If you purchased individual bonds, you may not have given much thought to whether you'd be able to sell them when you want to—a concept known as liquidity. After all, many investors purchase individual bonds for the income they provide, planning to hold the bonds until maturity. Nevertheless, it's important for all investors to consider the ease of buying and selling investments, and how cost-efficient it is to do so, when building a portfolio.
Liquid investments can be bought and sold with relative ease and without a significant change in price. Liquidity declines whenever it becomes more difficult to trade an investment due to an imbalance in the number of buyers and sellers or because of price volatility. In the case of bonds, investors should understand what professional bond traders already know: the bond market isn't always instantly liquid, and some bonds are easier to trade than others.
FINRA is issuing this alert to educate investors about bond liquidity, and the potential for decreased liquidity and investment losses for those who sell their bonds before maturity at a time of market stress. For example, rising interest rates generally cause bond prices to fall, which in turn can be accompanied by a bond market sell-off that might further depress bond prices. An increase in interest rates also could make it more challenging to sell a bond at a desirable price, especially bonds with longer duration. Similarly, a credit scare across an industry sector or with respect to a particular issue can have a dramatic liquidity impact.
This alert focuses on liquidity with respect to individual bonds and does not address liquidity issues related to bond funds.
Buying and Selling Bonds
Not all investments are bought and sold the same way. A market's structure dictates how trading takes place and impacts the liquidity of what is traded.
Most bonds trade through dealers who buy and sell bonds for their own account. This is different from exchange-listed stocks, where generally your broker acts as your agent and delivers the order to an exchange where a buy order is matched or crossed with a sell order.
In the case of most bond orders, if you place a sell order with your firm, it will offer to buy your bonds at a stated price. As part of that process, your firm will likely search the market to find other potential buyers, and may sell the bonds to another buyer immediately after purchasing them from you. Alternatively, the firm may buy your bonds and hold them, taking the risk that it will find a buyer(s) at a later time. The relatively recent development of electronic bond trading platforms has helped increase the efficiency of bond trading, but these platforms are not exchanges and a firm may not have linked to all of them.
The bond market is structured in this way because bonds have diverse characteristics, can trade in large blocks, and may trade infrequently. Many investors hold bonds to maturity—in other words, they collect interest payments throughout the life of the bond and then receive a return of principal at maturity. Unlike bonds, stocks do not mature—an investor must trade a stock to realize a return of principal. This contributes to a higher volume of trading activity in the stock market versus the bond market.
In the majority of bond transactions, a brokerage firm acts as principal, selling you a bond that the firm already owns.
When a firm sells you a bond in a principal capacity, it may increase or mark up the price you pay over the price the firm paid to acquire the bond. Similarly, if you sell a bond, the firm, when acting as a principal, may offer you a price that includes a mark-down from the price at which it believes it can sell the bond. The mark-up or mark-down is the firm's compensation.
If the firm acts as agent, meaning it acts on your behalf to buy or sell a bond, you may be charged a commission, which will appear on your trading confirmation.
Pressures on Bond Liquidity
A number of factors have the potential to put pressure on bond liquidity.
- Market breadth. The sheer number and diversity of bonds potentially affects liquidity. The market includes corporates, municipals and Treasuries to name a few, each with different characteristics and risk factors. Different bonds issued by the same company can have different characteristics. Assigning value and quickly matching buyers and sellers in a market with so many bonds and so little uniformity is no easy task.
- Dealer inventory. Since the financial crisis, many dealers have reduced their risk-taking and are not buying or holding as many bonds as in the past. With fewer buyers and sellers in the market, it may be harder for you or your broker to find a buyer willing to purchase your bond at a price you consider attractive, especially during periods of market volatility.
- Selling pressure. Any time multiple owners of a bond collectively seek to sell at the same time, liquidity may be reduced. Market corrections, domestic or global economic shocks, or interest rate increases could trigger many investors to sell bonds without many buyers interested in purchasing.
Investor Action: Questions to Ask
Even buy-and-hold investors who have no intention of selling their bonds before maturity can benefit from better understanding how bond markets work. These questions can help clarify how lower liquidity in the bond market could impact your bond holdings. Whether you are thinking about making a bond investment, or already own bonds, ask your broker or adviser:
- How does your firm handle bond trades, particularly sell orders? For instance, some firms have full-service bond desks that can commit the firm's money to purchase your bonds, or have arrangements with dealers that offer liquidity. Most firms also subscribe to one or more electronic bond trading platforms. A firm with these types of resources may be able to find liquidity when you seek to sell your bonds.
- How often has this security traded in the recent past? Bonds that consistently trade with relative frequency tend to have more potential buyers and greater liquidity than bonds that trade sporadically.
- In what price range has the security traded during that time period? Price swings (volatility) may make it harder to trade your bond, or increase the cost of your trade. Investors can go to FINRA's TRACE Market Data Center for real-time and historical transaction prices for corporate and agency bonds, and end-of-day prices for U.S. Treasury Bonds. Investors can also use the Municipal Securities Rulemaking Board's EMMA service. EMMA provides disclosures, trade data and other information related to municipal securities.
- Does your firm offer any fixed income analysis tools? These tools may help you model the impact of interest rate fluctuations on the value of your bond holdings. Not all investments will be equally affected by rising interest rates.
- How can I construct my bond portfolio to better meet my liquidity needs? Your broker or adviser can help you determine which securities may be better matched with short-term versus long-term liquidity needs. You may also want to discuss how you can construct a bond portfolio that is relatively more resilient to interest rate changes, particularly a rise in interest rates, and the pros and cons of doing so.
In addition to talking to your broker or adviser about these questions, read the information about your bond in the bond circular, information sheet or official statement. Pay close attention to information about the risks that the bond investment poses, including liquidity risk. Those risks can change over time, so be sure to read any supplements to the original disclosure documents that update investors. Ask yourself when, at various points over your investment horizon, you will need readily-available cash, and whether the cash flow from your bond investments will be consistent with your needs.
- FINRA Alert, Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio
- FINRA Market Data Center, Bond Market Center
- Municipal Securities Rulemaking Board (MSRB) provides disclosures, trade data and other information through EMMA
- SIFMA Investing in Bonds
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