Bond Market Liquidity

The bond market is huge, and so there's plenty of money to make it liquid. Yet a particular bond issue is often less liquid than a popular common stock.

Why do you think that would be the case?

No, that's not the main driver here. Consider what makes the most liquid securities so liquid.

Exactly. A share of SPY is like any other share of SPY, and so these can trade among many market participants without a lot of due diligence. But bonds are heterogeneous. They have varying features that make them different, including issuer, term, coupon, time of issue, embedded options, and seniority.

Highly unlikely. Stocks are riskier, and a lot of institutional investors can hold bonds but not stocks for exactly that reason.

Investors wanting bonds usually transact in the over-the-counter (OTC) market to get them. This means a dealer is matching buyers and sellers, each looking for the best prices. So there are search costs there. Newly issued bonds are on-the-run, and then as they get older, they become off-the-run. They also tend to get traded over time to investors who decide to hold them to maturity. What does that indicate about the relative liquidity between these two classifications?

Right!

No, on-the-run issues are.

Since off-the-run issues are more likely to be held, that means less trading and less liquidity. Some of the most popular bonds are safe government issues. Riskier bonds have a smaller group of investors to consider them, and so less liquidity. How would you then relate liquidity to yields?

Yes!

No, lower-yield bonds. Remember, those would be the safer bonds, like government issues.

Higher liquidity is found with safer bonds, meaning lower yields, and also on-the-run issues, meaning new bonds. Along those same lines as the on-the-run motivation, do you suppose a 1-year bond or a 10-year bond would be more liquid?

Right!

No, the one-year bond would be.

It's also logical since there is less interest rate risk with a shorter issue. So now it's safer, newer, and shorter issues that are more liquid. Finally, consider the size. Some bond indexes have a minimum face value to bother with inclusion, and then other investors work to replicate these indexes. Would you then expect a USD 1,000 face value bond or a USD 100,000 face value bond to have more liquidity?

No. It would be the bigger bond of USD 100,000 since it would be included in more indexes, making it more interesting to more investors.

You got it!

To summarize: [[summary]]

There's a lot of liquidity out there, but it depends on the issue.

Bonds have lower returns than stocks

Bonds aren't as homogenous as stocks

Bonds are disallowed from more investment policy statements than stocks

On-the-run issues are more liquid

Off-the-run issues are more liquid

Lower-yield bonds are more liquid

Higher-yield bonds are more liquid

1-year

10-year

USD 1,000

USD 100,000

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