Liquidity Dynamics in Fixed-Income Markets

We are continuing to examine a few foundational sub-topics before getting into the meat of the active versus passive debate for fixed-income. Last week, we looked at the composition and tax implications of fixed-income returns. Today we will be looking at liquidity in bond markets.

I find that the layperson is familiar with the stock market and understands that equities are traded electronically on centralized exchanges. Bonds are quite different however. Consider a few of the below points:

  • Many bonds are traded over the phone, rather than electronically. There is a big push towards electronic trading and a majority of US Treasuries may trade electronically now, but most corporate, mortgage, and muni issues still trade via phone.
  • There is no centralized exchange (electronic or otherwise), but a network of brokers and dealers who request quotes from one another.
  • Very few bonds trade on a given day. While nearly all stocks trade every day and many times over, very few bonds trade every day. Many US Treasury and Agency bonds trade every day, but a large portion of investment grade corporate bonds do not. A minority of high yield bonds trade on any given day and just a fraction of muni bonds trade on most days. For instance, both my clients and I own many bonds that have not traded in months.

Each of the above points contribute to wide bid-ask spreads. That is, the difference between what buyers are willing to pay and sellers are willing to accept is wide. When bid-ask spreads are tight and liquidity is deep, it does not much matter whether you’re a buyer or a seller because either will get close to the same price. But if bid-ask spreads are wide, then buyers and sellers will get quoted very different prices. Buyers will be quoted higher prices and sellers will be quoted lower prices. This type of market can be either good or bad, depending on the investor.

Investors who are forced to buy or sell are at a disadvantage. If an investor has some discretion over trading, he/she can exploit this illiquidity by selling when people want to buy and buying when they want to sell. The more illiquid the asset class, the more you want to be in control of buying and selling decisions. This dynamic certainly impacts how allocations evaluate manager mandates, fund structure, product wrappers, as well as management style (active vs passive) which we’ll get into more in coming weeks).