How Bond Liquidity Relates to Bid–Ask Spreads

Summary

The document explains why a less liquid corporate bond will often have a wider bid–ask spread than a comparable, easier-to-source bond. Investors may require compensation for the risk of holding an asset that could be difficult to sell, while the bond’s spread over Treasury yields may also be wider. This describes a general tendency, not a guaranteed relationship.

Trading volume, such as TRACE volume, is presented as a useful first estimate of how easy a bond is to source. However, volume is an imperfect liquidity measure: a bond that traded recently or frequently may still be difficult to obtain, and a lightly traded bond may be available. Consequently, volume alone does not determine the bid–ask spread, and the relationship is less direct than a simple comparison with highly liquid currency pairs might suggest.

Key ideas

• Less liquid corporate bonds are generally more likely to have wider bid–ask spreads than comparable liquid bonds.
• Investors may require compensation for the difficulty of selling a bond when they want to exit.
• Trading volume is a useful but imperfect proxy for how easy a bond is to source.
• The relationship between volume and bid–ask spread is not definitive.

Tags

# Spread determinants


# Spread determinants












Knowing that bond A is more liquid that bond B, i.e higher volumes are traded on bond A, does this information have any impact on the spread? Can we say that the large volumes traded on A will increase the spread between A and B? Does this work the same as online trading, e.g on Forex market, where EUR/USD will have the lowest spread, due to the greatest liquidity? I'm very confused about that, and hope someone can help.

## Answer by Dimitri Vulis (score 2)

https://quant.stackexchange.com/a/54901

If a corporate bond is less liquid / harder to source (e.g. it was issued years ago and most people who hold it now intend to hold it to maturity; or there just isn't a lot outstanding) then, ceteris paribus, the bid-ask spread is likely to be wider than comparable bonds; the spread on top of treasury yield is usually wider (to compensate for the risk of holding an asset that might be hard to sell if desired).

The volume (on Trace) is the best first approximation of how hard it is to source some bond, but still not perfect. It may turn out to be hard to find a bond that recently traded a lot and vice versa. For this reason, the relationship between volume and bid-ask spread isn't as clear.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.