Corporate Bonds and Liquidity: What Investors Need to Know
As of 2023, the combined global bond debt was around $97 trillion1. This includes both government bonds and corporate bonds. Out of this round figure, $34 trillion was applied particularly to corporate bonds. These figures are a testament to how reliable the bond investments are.
However, a common concern among investors is the conditions related to exiting a bond investment, especially when the market is volatile. This is where having an understanding of corporate bonds liquidity and strategies for managing liquidity becomes necessary.
This article will discuss all you need to know about corporate bond liquidity, what liquidity means, how to access the liquidity of corporate bonds in India and more.
What Does Liquidity Mean?
Liquidity is how fast and easily you can sell an asset without big price changes and convert it into cash. If your bonds can be easily sold because there is demand in the market, then they are liquid. However, if it can not be sold in the market easily, it's illiquid. The more liquid a commodity, the easier it is to sell and convert it into cash when needed.
How Liquid Is the Bond Market?
The liquidity of the bond market is affected by the type of bonds and their structure. Some common types of bonds are:
Treasury Bonds (Highly Liquid)
Bonds issued by the government are highly liquid as they are backed by the government. They are always in high demand as they are traded consistently.
Corporate Bonds (Less Liquid)
The corporate bonds' liquidity varies significantly based on the company, credit rating, and marketing conditions. Highly rated bonds (AAA-rated bonds) are more liquid than bonds that have low ratings.
Differences In Liquidity Between Corporate Bonds And Other Assets
Corporate bonds have different liquidity structures as compared to other assets like cash equivalents, stocks, or real estate. Here’s how corporate bonds liquidity is different:
Held till Maturity
Bonds are often held till their maturity period is over, which makes them less liquid and limits their trading frequency. Thus, bonds are considered long-term investments, as they are designed for stability and income. However, other assets like stocks and real estate can be traded easily in a secondary market and turned into cash.
High Denominations
Corporate bonds require high minimum investments, which makes them inaccessible for beginners and small investors. High denomination can result in an entry barrier by limiting accessibility and trading activity. However, other assets like stocks, ETFs, or mutual funds allow smaller investments and can be traded easily.
Market Dynamics
Factors like central bank policies, investor behaviour, and market conditions can significantly affect corporate bonds' liquidity. However, other assets like stocks have high market demand due to the frequency of trading and can be sold easily.
Why Is Liquidity So Important In Corporate Bonds?
Liquidity is crucial for both trading dynamics and the price of the corporate bonds. Some of the reasons why it is important are:
Efficient Trading
The high liquidity of an asset ensures that it can be easily traded on a large scale without any significant impact on price. This is especially important for institutional investors who deal in high volumes.
Yield Spreads
Bonds at different levels of risk possess different yield spreads. Safe, reliable, and highly rated bonds have a small yield spread and are highly liquid. However, high-yield bonds are more risky, provide a wide yield spread, and are less liquid.
Investment Accessibility
Limited accessibility due to high minimum capital investment makes the corporate bond market less dynamic than the stock market. This limits corporate bonds investment and makes bonds less accessible to small investors.
Factors Impacting Bond Liquidity
There are several reasons that can influence the liquidity of corporate bonds and affect their ease of trading. Some of them are:
Credit Ratings
Bonds with high ratings are considered safe investments and traded frequently with demand, making them more liquid. However, bonds with low ratings (junk bonds) are considered less liquid because they are more risky, and investors hesitate to purchase them.
Market Conditions
The stability of the economy plays a significant role in how the liquidity of bonds is affected. If the corporate bond market is in stable or booming conditions, then the bonds will be more liquid and can be traded easily. However, if the market condition is not favourable, then the liquidity of the bonds will be tightened.
Maturity Period
The maturity period is the time it will take for you to convert a bond into cash. Investors find it easier to trade in bonds with short-term maturity periods as they are more liquid and less risky. Long-term bonds offer high-yield spreads, but they are riskier and less liquid.
Bond Characteristics
Features like callable or convertible bond options can affect the liquidity of corporate bonds. Callable bonds allow the issuer to pay back the bond early and reduce liquidity. However, convertible bonds can be converted into equity, which attracts more buyers and potentially increases liquidity.
Assessing Liquidity
If you are wondering how you can assess the liquidity of a bond, here are some of the indicators that can guide you:
- Bonds with frequent buying and selling activity are highly liquid compared to those that are in less demand.
- The difference between the selling price and the buying price of the corporate bond is called bid-ask difference. A narrow difference indicates that the bonds have higher liquidity.
- Bonds with high ratings are more liquid compared to bonds with low ratings.
Challenges Of Illiquidity
For corporate bond investors, liquidity can have several challenges. Some of these are:
- Less liquid bonds have higher yield spreads, especially during market volatility.
- The high minimum investment value restricts the accessibility of small investors.
- Most of the corporate bond market is dominated by institutional investors, which creates liquidity risk.
Strategies For Managing Liquidity Risk
To manage the liquidity risk of corporate bonds, investors can adopt some of these techniques:
Risk Management
Diversifying the holding can help in reducing the risk. You can spread your corporate bond investment across various bonds and maturities. You can combine short-term bonds for immediate liquidity with long-term bonds of higher yield to create a balanced portfolio.
Focus on High-Rated Bonds
High-rated bonds have more liquidity and consistent demand in the market. Thus, focusing on high-rated bonds like AAA bonds reduces the risk of price impact. It will allow you to sell your holding whenever necessary without significant losses.
Analysing Market Indicators
The level of liquidity is affected by certain factors like investor base and market sentiments. Having an analysis of such factors can help in making informed decisions. Thus, it is advised that you thoroughly analyse market indicators like bid-ask spreads, trading volumes, and yield spreads to understand a corporate bond’s liquidity.
Conclusion
Liquidity affects everything from ease of trade to the yield spread of corporate bond investment. The more liquid your assets are, the easier it will be for you to sell them and convert them into cash. Thus, it is advised that before you start investing your hard-earned funds into corporate bonds, you must thoroughly research its liquidity risk and ensure it aligns with your interests.
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Frequently Asked Questions About Bond Liquidity
Q1. What increases bond liquidity?
The liquidity of the corporate bond investment can increase by factors like higher credit rating, narrow differences in bid-ask spread, and trading activity of the bonds. Additionally, bonds with shorter maturity periods are usually more liquid.
Q2. What types of corporate bonds are typically more liquid?
Corporate bonds with short-term maturity periods, high credit rating (AAA bonds), and bonds with simpler structures like non-callable and no-convertible bonds are typically more liquid.
Q3. How do exchange-traded funds (ETFs) affect bond liquidity?
Exchange-traded funds (ETFs) provide ease of trade with small investments and frequency of trading. Additionally, investors can trade ETFs indirectly on the stock market, which makes them more liquid and easier to trade.
References
1. UNCTAD, Accessed at https://unctad.org/publication/world-of-debt#:~:text=Global%20public%20debt%20has%20reached,fast%20as%20in%20developed%20economies.
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