Why Liquidity Matters in the Corporate Bond Market

The importance of liquidity in corporate bond markets is undeniable. Liquidity of any corporate bond majorly influences its ability to be quickly traded in the market, i.e. how easily you can sell it and whether there is an active buyer market for the same.

Liquidity is vital for reasons like enhancing investor confidence, price efficiency, market resiliency, credit ratings, and accessibility to assets. 

Liquidity has a sizable effect on bond prices and yield spreads, especially during economic downturns. There are various factors influencing corporate bond liquidity, as we will discover below.

What is Liquidity in the Bond Market? 

Liquidity in corporate bond markets is a concept that needs a deeper understanding. When the bond market enables the trading of low-cost and large-scale assets without causing any major price change, it is considered liquid.

So, if an investor can sell his/her bond without facing any investment loss, the market is perceived as liquid. It goes without saying that several factors may influence market liquidity, and it may fluctuate, particularly during economic downturns. Credit ratings are also a key influence in this case. 

The bond market operates differently from the stock market; unlike stocks, bonds come with maturity dates. Bondholders may hold till maturity, and they do not trade as frequently in the market. 

Are Bonds Liquid or Illiquid?

Bonds are not technically illiquid assets for you to invest in, although their liquidity levels may be lower than cash and cash equivalents, among other kinds of assets. This is because you have to hold them until the maturity date and then redeem them.

You may come across the concept of a liquidity premium in bonds, referring to the extra compensation that is paid to investors in any bond that is harder to sell swiftly at a fair market price. 

Although corporate bond liquidity is sporadic, it is gradually increasing due to improvements and investor-friendly market reforms. The growing presence of bond investment platforms is enhancing retail participation and investments considerably. Thus, bonds issued by leading entities and NBFCs now attract a broader investor base and have higher trading volumes.

SEBI and RBI data indicate that corporate bond trading volumes have gone up over the year. Yet, a large part of trading is dominated by institutional investors and private placements instead of retail trades in the open market. There are also thinly traded bonds which cannot be sold or exchanged for cash easily without significant price changes. They are exchanged in lower volumes and have limited numbers of buyers and sellers.

However, despite these factors, it can be said that liquidity is decent for corporate bonds, making them attractive investment options. 

How Liquidity Affects Corporate Bond Investing

The importance of liquidity in bonds is evident, seeing as it has a massive impact on investments. Corporate bond liquidity makes it easier to buy and sell bonds in the secondary market within a reasonable duration and without significantly impacting their prices.

As a retail investor, you are more likely to invest in the bond market when you are assured of an easy exit in case there is any need for the same. 

Easy liquidity also benefits the corporate bond issuer, since it reduces the cost of borrowing. Bonds with perceived liquidity naturally have higher demand, helping companies raise capital at better rates.

Alternatively, companies have to offer their illiquidity premium in the form of higher yields to draw more investors. This increases the cost of capital as a result. Liquidity is also crucial for the health of the financial system throughout the country.

A more liquid and broader bond market offers an option to the traditional banking and financial system, diversifying capital sources available to companies for raising funds. 

Why Corporate Bonds Tend to Be Less Liquid

There are several corporate bond market risks that investors have to contend with, chief among them being liquidity. This risk arises from the inability to quickly trade the investment and convert it to cash without any loss in value.

The Indian secondary bond market is not as liquid as the equity market in the country. Most bond investments here are held till maturity, thereby reducing liquidity in the secondary market (since trading volumes are low). 

At the same time, bond investments are usually focused more on high-rated and investment-grade bonds. This naturally affects the trading volumes of speculative bonds. Hence, as an investor, you may encounter liquidity hurdles in corporate bonds and may have to wait for some time before converting your investments into cash. It’s essential to avoid parking your first layer of emergency funds into these bonds. Yet, corporate bonds still bolster your portfolio, since they often provide attractive and inflation-surpassing returns, while generating regular income simultaneously.

The relationship between bond spreads and liquidity is also important. Less liquid bonds have higher yield spreads, particularly during volatile periods in the market. 

Measuring Liquidity in Corporate Bonds

Learning how to measure bond liquidity is easy; here are some pointers worth noting in this regard. 

• Trading Volume & Frequency- Bonds are listed on exchanges to offer investors a way to liquidate these assets before the date of redemption. Listed bonds that trade regularly on the NSE or BSE have higher liquidity than bonds with lower trading volumes. 
• Bid-Ask Spread- It refers to the difference between the bid (selling price) and ask (buying price). You should consider investing in a bond that has a narrower bid-ask spread, since it is an indicator of higher liquidity. 
• Credit Rating- These ratings indicate the repayment abilities of borrowers. The higher these ratings, the safer your bond. Bonds which have higher ratings are usually seen as more liquid in comparison to speculative and riskier bonds. 
• Maturity Profile & Issue Size- Larger bond issues usually have higher liquidity due to a wider investor base in comparison to smaller issues, which may be held closely. Bonds with shorter maturities are also more liquid than those with long or ultra-long durations. This is because shorter-maturity bonds come with lower interest rate-related risks, making them more compelling for investors. 

Role of SEBI and RBI in Improving Liquidity 

There are several proactive RBI and SEBI guidelines for bond market liquidity. Some of them include: 

• Centralised bond data platforms have been introduced for real-time volume and price transparency.
• Public bond issuance has been encouraged over private placements to boost price discovery.
• Listing requirements have been simplified for corporate bonds, particularly in the case of non-financial firms. 
• Partial credit enhancements and securitisation structures have been introduced to enhance access for lower-rated issuers. 
• OBPPs (online bond platform providers) have been formed and regulated to ensure a safe gateway (SEBI-registered) for retail investors. It is easier to access listed bonds through these digital platforms. 
• The minimum investment has been lowered to ₹1,000, considerably reducing the entry barriers for retail market participants and expanding the base of investors. 

How Investors Can Manage Liquidity Risk in Bonds

Managing liquidity risks in bonds requires following these steps: 

• Risk Management Strategies
  Diversifying bond holdings can help lower risks considerably. You can spread your bond investments across multiple maturities and bonds.
  Another strategy involves combining short-term bonds with immediate liquidity, with higher yield, and long-term bonds for a more balanced portfolio. 
• High-Rated Bond Focus
  Demand and liquidity are both higher for bonds which have higher ratings. Hence, concentrating on high-rated bonds like AA or AAA will lower the risks of any impact on prices. You can thus sell holdings whenever required without incurring major losses. 
• Evaluating Market Indicators
  Liquidity levels are impacted by several factors, such as market sentiments and the investor base. Evaluating these factors will help you make better decisions. You should also gain an understanding of indicators like trading volumes, bid-ask spreads and yield spreads to understand the liquidity of any corporate bond. 

Conclusion

As you can see, liquidity in corporate bond markets is worth understanding before committing to any investment. Based on the above-listed risks and current market trends, the liquidity levels of these assets can be classified as decent at least. Hence, you may consider investing in them, provided you do your homework on all these aspects carefully.