What Determines Bond Liquidity?

by Walter Johnson

Bond liquidity refers to the ability of bonds to be traded at low cost. “Liquidity” in other contexts refers to the available pool of cash; therefore, it is used in a slightly different way when referring specifically to bonds. Since many people buy bonds as a means to diversify and hedge other investments, bonds are often not traded at all. The big issue therefore, is what specific factors must exist in order for liquidity to rise in money markets.

Crisis

The basic consensus as of 2011 is that crisis periods in the domestic or global economy are an important cause of bond liquidity. If there is news that the economy will soon dip into recession, bonds suddenly are traded at fairly high volumes. If the economy is stable or predicted to grow, the bond market stays relatively illiquid.

Stocks

There is some evidence that stocks and bonds cause each other to be traded with greater rapidity. If the stock market sees a high level of volatility, the bond market is sure to see this too. The same exists in reverse. This is not a causal concept, only that the two markets affect each other regularly, especially in terms of volatility. Therefore, all other things being equal, if the stock market sees a sharp increase in volume, then the bond market should soon see such a period too.

Rates

Interest rates have long been an important cause of bond liquidity. If interest rates are expected to fall, then presently held bonds are worth more money. If you are holding a bond at 5 percent, and rates are expected to drop to 4.5 percent, then the bond you hold is worth more money than when you bought it. If this is the case, then trading will increase so as to cash in on the new value — people will want your bond rather than the lower-rate bonds issued when rates fall. At the same time, if rates are expected to rise, people want to dump their current lower-rate bonds. Therefore, changes in rates in either direction will cause a greater rise in basic volatility. In general, it is when rates are expected to rise that liquidity increases the most. Hedgers who want long-term bonds as a way to protect other investments might hold onto bonds that are growing in value due to predictions of rate dips in the future.

Time of Year

The New York Federal Reserve bank reports that summer and early fall are the times of highest bond liquidity, while Friday is the day of the week when liquidity is at its lowest. The summer may well be the most active season because Congress is not generally in session, and new laws that might affect the markets have not been put in place. The political atmosphere during the summer is calmer than in mid-fall, since Congressmen are too busy campaigning at home to worry about financial law.

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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