Fresh corporate bonds have flooded the market in recent months as companies have taken advantage of low interest rates to load up their balance sheets with cheap debt. But investors who snapped up some of these new issues should be aware of their liquidity, as they may find it difficult to sell these securities before maturity.
Liquidity can make the difference between a potentially profitable investment and a likely loser when trading in the bond market. When there is a lot of liquidity, bid-ask spreads may be just a tiny basis point or two – in other words, one- or two-hundredths of 1 per cent. Without liquidity, sellers can be forced to wait for hours or even days for buyers – or they may wind up having to sell at much lower prices than they anticipated.
“Liquidity is there until it’s not. You have to enjoy it as long as it lasts,” says Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management Inc. in Toronto.
Bonds, particularly some corporate issues, can easily be illiquid. Unlike big corporate names and big issues, which trade easily with small bid-ask spreads, lesser-known names or riskier issues that have weak protections for investors can be difficult to trade without discounts, or larger bid-ask spreads. These discounts offer a measure of protection for the buyer. If the seller accepts a low price, then the seller is discounting the bond because of its illiquidity.
One reason for a bond’s illiquidity is unfamiliarity with the issuer. Another is more technical, as each issue of a corporation’s bonds may differ in ranking or seniority. Some bonds need to be sold at a hefty discount of dozens of basis points – if they trade at all. These seldom-traded illiquid bonds can have gaps of $10 on a bond previously quoted at $100. That’s a 10-per-cent difference, and when bonds have low single-digit coupons, such spreads can turn a profit into a loss.
Yet, some investors who are willing to take on low-grade bonds or those of troubled companies may seek to take advantage of illiquidity. That’s because existing holders of illiquid bonds of a company in crisis may be so desperate to get a bid that they accept a hefty price cut, says Adrian Prenc, vice-president, portfolio manager and chief risk officer at Marret Asset Management Inc. in Toronto, an affiliate of CI Investments Inc., and a bond dealer known for its expertise in non-investment-grade debt.
“It can happen in restructurings or when a bond is not eligible for inclusion in an exchange-trade fund (ETF),” he says.
Unlike stock trading, in which dealers just get a commission, dealers trade bonds as principals and they care a great deal about getting a high price when they sell and paying little when they buy. Moreover, they don’t want to get stuck with bonds that their usual customers – including bond mutual funds, ETFs and institutions such as university endowments and insurance companies – don’t want. Even a $500,000 lot of perfectly sound bonds from an obscure issuer may wind up homeless or stuck in a dealer inventory with no trades.
In this tug of war, the bond’s price depends on the bond’s inventory and a counter-party that wants to trade it. It’s more like trading used cars than buying groceries with posted shelf prices. Professional investment managers can call several dealers to seek competitive prices. Few independent investors can do that.
“For the retail buyer in this opaque and sometimes illiquid market, discovering the market price and figuring out the spread is virtually impossible,” says Norman Levine, managing director at Toronto-based Portfolio Management Corp., an independent discretionary portfolio manager. “Institutional investors can shop a deal or check the price on Bloomberg or other services, but in bonds, the price difference between dealers can be as much as a percentage point. That can be the difference between a good investment and a bad one [when bonds are paying in the low single digits].”
Another consideration when it comes to liquidity in the bond market is that during times of crisis, bid-ask spreads widen significantly. Then there are times when liquidity dries up and there are no trades. That can happen in free-fall markets when holders want out at almost any price.
For example, during the financial crisis in the autumn of 2008, most investors wanted to reduce leverage and sell almost everything except for short-term government bonds, which are essentially cash. Some days, there were no bids, recalls Vivek Verma, portfolio manager at corporate bond specialty investment firm Canso Investment Counsel Ltd., in Richmond Hill, Ont. “Spreads widen as bond quality goes down or the market gets illiquid.”
In the bond market, liquidity or tradeability can’t be taken for granted. There is not much of a problem with government bonds, but any corporate bond can get into the dreaded state of being untradeable if the issuer gets into trouble.
“Illiquidity is a transactional risk,” says Chris Kresic, head of fixed-income and asset allocation at Jarislowsky Fraser Ltd., in Toronto. To guard against not being able to get a good selling price when they want out, some bond managers hold out so long that short-term price spreads don’t matter much.
“Our average hold period is more than seven years,” he says.
For those investors looking to avoid holding on to bonds that may become illiquid, the answer is to invest in bond ETFs. That’s because portfolio managers have the clout to trade bonds with tiny bid-ask spreads and ETFs’ market prices are as visible as those of any stock for investors.
Bond ETFs trading costs per dollar will be less than the cost of trying to buy or sell retail-size lots of bonds. But that comes at a cost, Mr. Levine says: “You don’t have an end price for the ETF. For an actual bond, it’s face value at par.
"Thus, the downside of eliminating the liquidity problem is the investor’s loss of ability to redeem for face value at maturity.”