What is bond liquidity?

A bond is considered to be liquidif it can be bought or sold at the prevailing market price quickly and at a low cost. Liquidity can affect the bond’s price and subsequent investment returns. A bond’s liquidity is affected by the issuer’s credit rating and the amount of the bond issued and outstanding. For example, if an issuer is in financial distress it becomes more difficult to find investors willing to purchase the issuer’s bonds. As willing buyers become harder to find, it becomes harder to sell the issuer’s bonds, thus the bond’s liquidity diminishes.

In 2002, for example, as rumours of Telus Corporation’s financial difficulties drove the company’s common shares to trade under $10.00 per share, the company’s bonds became very illiquid. The only way an investor could find a willing purchaser was by dropping the bond’s selling price to under $80.00 per $100.00 of par value. The buyer at that time demanded a higher rate of return to compensate for the perceived increased risk. In this case, the bond’s lack of liquidity depressed the bond’s price. The effects of liquidity on bond prices and returns show that liquidity is an important factor for bond investors.

In addition, large bond issues have better liquidity than small issues.

In Canada, bonds trade in dealer-based over-the-counter secondary markets. In such a market, the market’s liquidityis provided by investment dealers and other market participants dedicating risk capital to trading activities. In the bond market when an investor buys and sells a bond, the counterpartyto the trade is almost always a bank or securities firm acting as a dealer. In most cases, when a dealer buys a bond from an investor, the dealer is doing so with the intention of holding the bond within its own bond inventory. In some cases, the dealer might immediately resell the bond to another investor.

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