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After all, many investors purchase individual bonds for the income they provide, planning to hold the bonds until maturity. Liquid investments can be bought and sold with relative ease and without a significant change in price. Liquidity declines whenever it becomes more difficult to trade an investment due to an imbalance in the number of buyers and sellers or because of price volatility.
In the Factors to consider when choosing a of bonds, investors should understand what professional bond traders already know: FINRA is issuing this alert to educate investors about bond liquidity, and the potential for decreased liquidity and investment losses for those who sell their bonds before maturity at a time of market stress.
For example, rising interest rates generally cause bond prices to fall, which in turn can be accompanied by a bond market sell-off that might further depress bond prices. An increase in interest rates also could make it more challenging to sell a bond at a desirable price, especially bonds with longer duration.
Similarly, a credit scare across an industry sector or with respect to a particular issue can have a dramatic liquidity impact.
This alert focuses on liquidity with respect to individual bonds and does not address liquidity issues related to bond funds. Buying and Selling Bonds Not all investments are bought and sold the same way.
Most bonds trade through dealers who buy and sell bonds for their own account. This is different from exchange-listed stocks, where generally your broker acts as your agent and delivers the order to an exchange where a buy order is matched or crossed with a sell order.
In the case of most bond orders, if you place a sell order with your firm, it will offer to buy your bonds at a stated price. As part of that process, your firm will likely search the market to find other potential buyers, and may sell the bonds to another buyer immediately after purchasing them from you.
Alternatively, the firm may buy your bonds and hold them, taking the risk that it will find a buyer s at a later time. The relatively recent development of electronic bond trading platforms has helped increase the efficiency of bond trading, but these platforms are not exchanges and a firm may not have linked to all of them.
The bond market is structured in this way because bonds have diverse characteristics, can trade in large blocks, and may trade infrequently. Many investors hold bonds to maturity—in other words, they collect interest payments throughout the life of the bond and then receive a return of principal at maturity.
Unlike bonds, stocks do not mature—an investor must trade a stock to realize a return of principal. This contributes to a higher volume of trading activity in the stock market versus the bond market.
Broker Compensation In the majority of bond transactions, a brokerage firm acts as principal, selling you a bond that the firm already owns. When a firm sells you a bond in a principal capacity, it may increase or mark up the price you pay over the price the firm paid to acquire the bond.
Similarly, if you sell a bond, the firm, when acting as a principal, may offer you a price that includes a mark-down from the price at which it believes it can sell the bond. If the firm acts as agent, meaning it acts on your behalf to buy or sell a bond, you may be charged a commission, which will appear on your trading confirmation.
Pressures on Bond Liquidity A number of factors have the potential to put pressure on bond liquidity. The sheer number and diversity of bonds potentially affects liquidity.
The market includes corporatesmunicipals and Treasuries to name a few, each with different characteristics and risk factors. Different bonds issued by the same company can have different characteristics.
Assigning value and quickly matching buyers and sellers in a market with so many bonds and so little uniformity is no easy task. Since the financial crisis, many dealers have reduced their risk-taking and are not buying or holding as many bonds as in the past.
With fewer buyers and sellers in the market, it may be harder for you or your broker to find a buyer willing to purchase your bond at a price you consider attractive, especially during periods of market volatility. Any time multiple owners of a bond collectively seek to sell at the same time, liquidity may be reduced.
Market corrections, domestic or global economic shocks, or interest rate increases could trigger many investors to sell bonds without many buyers interested in purchasing.
Questions to Ask Even buy-and-hold investors who have no intention of selling their bonds before maturity can benefit from better understanding how bond markets work. These questions can help clarify how lower liquidity in the bond market could impact your bond holdings.
Whether you are thinking about making a bond investment, or already own bonds, ask your broker or adviser: How does your firm handle bond trades, particularly sell orders? Most firms also subscribe to one or more electronic bond trading platforms.
A firm with these types of resources may be able to find liquidity when you seek to sell your bonds. How often has this security traded in the recent past? Bonds that consistently trade with relative frequency tend to have more potential buyers and greater liquidity than bonds that trade sporadically.
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