Your Money: What makes a bond illiquid, compared to a stock

December 28, 2020 12:30 AM

Compared to corporate bonds, treasury bonds or bonds issued by the government are more liquid

The longer one has to wait to liquidate an investment, the greater is the interest income that is foregone.The longer one has to wait to liquidate an investment, the greater is the interest income that is foregone.

By Sunil K. Parameswaran

Liquidity is a major factor when considering investment in a security. In a liquid market there will be plenty of buyers and sellers. If the market is characterised by a many buyers, their buying pressure is likely to make prices zoom up. On the contrary, if the market is characterised by too many sellers, prices are likely to be depressed. It must be remembered that time is also money. The longer one has to wait to liquidate an investment, the greater is the interest income that is foregone.

Liquidity in investments
Stock markets are fairly liquid compared to bond markets. Blue chip stocks, in particular, are highly liquid. The psychology of stock traders is to buy on expectation of a capital gain, and then book profits when they feel that the market has plateaued. Subsequently if the prices decline sharply, such investors will re-enter the market in the form of long positions. Bond traders are, however, wired differently. When an issue is new, there will be active buying and selling activities, and consequently, liquidity is unlikely to be an issue. However, once the bond becomes seasoned, most holders will simply hold the security to maturity, while collecting coupon payments along the way.

For a given maturity, the most recently issued bond is said to be on-the-run. A security with the same term to maturity, but which has been issued earlier, is said to be off-the-run. Due to the psychology of bond traders, on-the-run securities are more liquid than off-the-run securities. Consequently, while both are structurally identical, the former are characterised by higher prices, which means lower yields.

Bonds are relatively illiquid
A second reason why bonds are relatively illiquid compared to stocks, is because there are too many of them in the market, which differ with respect to the coupon, month of maturity, and the year of maturity. Consequently, each security sees limited trading. Municipalities are big issuers of bonds in countries such as the US. At any point, a buyer has access to almost two million types of issues.

Stocks are usually traded on an exchange. In India, with the entry of the National Stock Exchange, transparency and liquidity have increased tremendously. The most sought-after stocks are characterised by high liquidity, and investors can buy and sell easily. However, very few bonds are traded on exchanges. Most of them trade over-the-counter (OTC), in a market made by dealers and brokers. While stock market data is regularly disseminated and is easily available to potential investors, data on bond prices and yields is hard to get.

Compared to corporate bonds, treasury bonds or bonds issued by the government are more liquid. This is true for two reasons. The number of treasury issues available at a point in time is lower than the number of corporate bonds available. Also, the size of a treasury issue is much bigger than that of a typical corporate bond issue. Consequently, for each maturity date, the availability of treasury bonds is greater.

The writer is CEO, Tarheel Consultancy Services

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