Explain how liquidity varies across the bond market and its sub-sectors, and discuss how it affects the running of a bond portfolio
The idea
Most bonds trade over the counter through dealers, and many issues trade rarely after issuance, so liquidity is thinner than in equities. Sovereign bonds, especially recently issued benchmark issues, are the most liquid; seasoned issues, corporate bonds, high-yield, emerging market, securitised and municipal bonds are progressively less so. For the manager, illiquid bonds offer a yield premium but cost more to trade, are often priced by matrix or model rather than observed trades, and may be impossible to sell in stress. Managers therefore balance yield pickup against liquidity needs and may use futures, swaps or bond ETFs as liquid substitutes. A trap is valuing illiquid bonds at stale prices.
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