If you purchased individual bonds for the income they provide and plan to hold the bonds until maturity, you may not have given much thought to whether you’d be able to sell them if you wanted to or how cost-efficient it is to do so when building a portfolio. This concept is known as liquidity.
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 that the bond market isn't always instantly liquid, and some bonds are easier to trade than others.
While liquidity varies from bond to bond, the potential for decreased liquidity and investment losses exists for investors 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 might also 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 might have a dramatic liquidity impact.
Understanding the Bond Market
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 brokerage firm acts as your agent and delivers the order to an exchange or alternative trading system 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. Your firm will likely search the market to find other potential buyers and might sell the bonds to another buyer immediately after purchasing them from you. Alternatively, the firm might buy your bonds and hold them, taking the risk that it will find a buyer(s) at a later time. The development of electronic bond trading platforms has helped increase the efficiency of bond trading, but these platforms are not exchanges, and a firm might 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 might trade infrequently. Investors who hold bonds to maturity collect interest payments throughout the life of the bond and then receive a return of principal at maturity. Unlike bonds, stocks do not mature—investors must trade stocks to realize a return of principal. This contributes to a higher volume of trading activity in the stock market versus the bond market.
Bond Liquidity Pressures
A number of factors have the potential to put pressure on bond liquidity. These include selling pressure (a rush to the exits by bond owners) and limited dealer inventory (supply) of bonds. The central bank—the Fed—can also put pressure on liquidity when, for instance, it tightens up its balance sheet by declining to purchase new Treasury securities to replace bonds that have matured (often called quantitative tightening). In addition, the sheer number and diversity of bonds potentially affects liquidity: assigning value and quickly matching buyers and sellers in a market with many bonds and little uniformity can create liquidity pressure.
Investor Action: Ask Questions
To clarify how liquidity, or lack of it, in the bond market could impact your holdings, use your firm’s online resources or ask your investment professional the following questions:
1. 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 might be able to find liquidity when you seek to sell your bonds.
2. 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. You can use FINRA’s Fixed Income Data to find fixed income security and trade information including real-time and historical data on bonds and other fixed income products and aggregate data on fixed income markets.
3. In what price range has the security traded during that time period? Price swings (volatility) might make it harder to trade your bond or increase the cost of your trade.
4. Does your firm offer any fixed income analysis tools? These tools might 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.
5. How can I construct my bond portfolio to better meet my liquidity needs? Your investment professional can help you determine which securities might match better with short-term versus long-term liquidity needs. You might also want to discuss how you can construct a bond portfolio that’s relatively more resilient to interest rate changes, particularly a rise in interest rates, and the pros and cons of doing so.
In addition, read the information about your bond in the bond circular, information sheet or official statement. Pay close attention to any discussion 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’ll need readily available cash and whether the cash flow from your bond investments will be consistent with your needs.