The stock market is the most liquid and active market as virtually any stock can be bought and sold instantaneously in sufficient quantity, but few investors know that the bond market is actually larger in dollar volume. Although not as active as stock or option trading, bond trading plays an important role in bond issuance, pricing, liquidity and use.
Bonds are considered long-term investments that provide current income. Investors are generally reluctant to buy illiquid investments -- that is, investments that they cannot sell quickly for a fair price should the need arise. Bond trading makes it easier to issue and sell bonds because it assures investors that they can always sell their bonds if needed.
The ability of one investor to sell a bond is an opportunity for another to buy it. Bond trading makes a large variety of bonds available to investors. A small investor can always find a bond that meets his current needs; an institution can sell and buy bonds to react to changing market conditions or investment objectives.
Bond trading provides fair pricing. The bond market may not be as active as the stock market, but it is based on the same continuous auction principle: each price is set through negotiation between a buyer and a seller.
Bond trading helps adjust bonds for current risks. When a bond is issued, the issuer's ability to repay is rated by several credit rating agencies. Lower-rated bonds must offer higher interest to compensate investors for the higher risk. A lot can happen to an issuer in the 30 years that a bond is outstanding. An issuer may have a high credit rating when a bond is issued, but its financial condition could deteriorate, subjecting its bondholders to additional risk. Credit rating agencies may downgrade a bond if an issuer's condition deteriorates. A downgrade would cause a downward adjustment in the bond's price.
Bond trading must ultimately be profitable, otherwise nobody would be interested in facilitating or engaging in it. Bond trading generates fees for the exchanges and brokers and offers profit potential to bond traders.
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