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Since the financial crisis in 2008, there has been a steady decline in the amount of liquidity in many investment markets, including equities, foreign exchange, and most notably, the bond market. The concern in the bond market has become an increasingly frequent topic of conversation with advisors in recent months, as the potential for rising rates is once again returning to the forefront.
What is liquidity?
On the surface, liquidity seems to be pretty easy to understand. It is the ability to buy or sell securities easily. Equities and ETFs appear to be liquid because they trade on an exchange where you can buy and sell anytime between 9:30 and 4:00 p.m. Prices at which people are willing to buy and sell are continuously posted, and this information is available to anyone.
Mutual funds are also liquid, since you can place your order to buy or sell before the close of business, and you will receive that day’s price.
The bond market is a little murkier, because there is no real public market for bonds. Bonds trade through an over-the-counter market, dominated by a few big players, making it a bit of a mystery for the average investor. But does that make it any more or less liquid than equities?
Notice how I said that equities “appear” to be liquid. They are, in the sense that somebody is often willing to buy or sell. However, once you get out of some of the heavily-traded names, the spread between the last price – the price at which someone is willing to buy and the price at which somebody is willing to sell – can become very wide. This large spread can often make it extremely difficult to buy or sell at a price you believe is what something is worth. In this case, the liquidity may not be as good as you may think.
Perhaps a more fitting definition would be what is quoted in Investopedia, which defines it as “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.”
Bond market liquidity
In the bond market specifically, liquidity is a little tougher to see because of the way the market works. Unlike equities, where there is an organized exchange, the bond market is much more fragmented. Often, it is not another investor who will be buying or selling you the bonds you want, but instead it is an investment dealer.
For you to sell a bond, there has to be an investment dealer who is willing to buy it from you. In recent years, increased regulation has made it costlier for an investment dealer to hold a lot of bonds on their books. Further, after the financial crisis, and with the prospect of rising yields, many dealers simply have a lower appetite for risk and are unwilling to hold a lot of bonds that are very likely to fall in value in the next few years. According to Bill Kim, a bond manager with Dynamic Funds, there has been a marked reduction in market turnover and a shrinking repo market.
How lower liquidity will affect you
A lower level of liquidity will have a significant impact on the bond markets. A key effect will be an increased cost of trading. I’m not talking about trading commissions here, but instead about the potential for wider spreads between bid (buy offers) and ask prices (sell offers). With fewer people willing to trade bonds, it is inevitable that these spreads will widen, with lower bids and higher asks.
With the lower trading volumes, it is highly likely that we will see an increase in bond market volatility. Again, with fewer participants willing to step up and buy or sell, any movements in prices will be amplified. With higher volatility, investors may become even more cautious, further dampening the overall levels of liquidity.
How can you protect against lower liquidity
As an individual investor, it is going to be extremely difficult to avoid any liquidity issues that may arise. But there are a few steps you can take to try to minimize it.
1. Invest in a bond fund or ETF.By investing in a wider pool of bonds, you can help to offset the liquidity problems of any one particular bond issue. Further, an actively managed bond fund can take steps to help protect investors in the face of lower liquidity.
2. Stick to higher quality issues.In any crisis, there is a flight to quality. By focusing on high-quality investment-grade issues, there is a higher probability that you can find a buyer or seller more easily if necessary. More investors would be willing to step in and take a Government of Canada or blue-chip corporate bond off your hands over a lower-quality high-yield offering. There may be certain bonds that will have a “no bid” situation where there are no buyers at any price, similar to what we saw in 2008.
3. Lower your duration exposure.The shorter the duration, the lower the risk, all things being equal.
Bottom line
Bond market liquidity is likely to be a topic of conversation for a long time to come. This will be particularly true once central banks begin to move rates higher. It will make investing in the fixed-income markets very challenging for all investors. Apart from cash, there are very few places to hide, but you can take some measures to help protect yourself, including diversifying your holdings, focusing on quality, and shortening your duration.
Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
