Fixed Income 101: Liquidity

What is liquidity?

Liquidity is defined as the ability to buy or sell assets at speed, in sufficient size, with minimal price impact. An issuer is considered liquid if its bonds trade regularly, attract a deep pool of buyers and sellers, and command tight bid-ask spreads. 

In the fixed income universe, which encompasses a diverse range of securities, from the most liquid and frequently traded government bonds to more specialised areas such as private credit, liquidity is particularly important. Liquidity is enhanced by broad investor participation in secondary markets, which allows investors to rotate positions with limited transaction costs. 

Indicative liquidity spectrum in fixed income 

Liquidity is not binary 

Liquidity is more complex than viewing assets that trade frequently as liquid and those that do not as illiquid. A sterling HY bond, for example, may be less liquid than a French sovereign bond, but that does not mean the bond will not trade. In fact, some of the bonds considered “less liquid” do still trade daily. 

Liquidity is not just whether an asset can be sold at all, but at what size, timeframe and price it can be sold. Some bonds may trade infrequently, not because there is no demand for them, but because they are held by long term investors. Even less frequently traded bonds can find buyers, though selling them quickly may require a price concession.

Liquidity in fixed income has evolved 

Before the Global Financial Crisis (GFC), large investment banks were the primary market makers in fixed income and would hold significant liquidity on their balance sheets. Investors bought and sold bonds through dealers at financial institutions who would provide liquidity while holding the risk. 

Since the GFC, increases in the cost of capital and regulatory requirements have made it more expensive for banks to hold assets. This has reduced dealer balance sheets and contributed to a shift towards electronic trading, cutting the ability of market makers to hold risk. As a result, market volatility is increasingly affecting liquidity in fixed income.

Drivers of liquidity

Size

• Larger bonds typically attract broader demand from institutional investors and greater dealer coverage, supporting a liquid secondary market. 

Issuer frequency

• Frequent issuers often have multiple bonds outstanding across different maturities. This helps to create a liquid issuer curve, allowing investors to compare bonds that may rank pari passu with debt from the same issuer and trade between tenors frequently. 

Credit rating 

• A higher rating typically gives an issuer access to a wider pool of investors, particularly those with IG only mandates. This helps to support a deeper secondary market, especially during a market downturn where investors traditionally rotate towards higher rated assets. 

Investment structure

• More senior debt often has a broader pool of investors to target than more complex and specialised securities such as additional tier 1 (AT1) bonds, even if both bonds come from the same issuer. As we move down the subordination structure and as debt becomes more junior and specialised liquidity is generally reduced

Investor base and dealer support

• A broad investor base can improve secondary demand if portfolio managers need to reduce or exit a position. Larger bookrunners can help distribute bonds at issuance via their market making network, supporting secondary market liquidity.

Why liquidity matters for portfolio managers 

In portfolio construction, we view the most important part of asset selection as being the fundamental analysis of a bond/issuer; however, liquidity remains a key consideration for portfolio managers when determining whether to invest in a bond. During periods of market stress, liquidity can dry up, resulting in wider bid-ask spreads and larger price concessions. Managers may therefore move up the credit quality curve and focus on more frequently traded assets. To prepare for this, they maintain a sufficient allocation of liquid assets, helping them meet redemptions without being forced to sell high conviction holdings on unattractive terms. 

For active portfolio managers, liquidity influences position sizing. They may be comfortable owning a relatively modest allocation of a bond if it can be traded efficiently. Owning a larger share of the same issue could make exiting the position more difficult and reduce flexibility. 

The appropriate liquidity profile also depends on the fund’s holding periods and investment horizons. A strategy which holds long term investments, with long term funding, can hold less liquid assets, which it can expect to hold until maturity to capture the associated illiquidity premium reflected in higher spreads or yields. By contrast, open-ended funds, which may be daily dealt and see regular redemptions, will often require a larger allocation of liquid assets. Stress testing supports this process by helping managers to identify whether there are sufficient cash and liquidity buffers to withstand market shocks and remain aligned with their investment mandate. For managers with multiple strategies, liquidity is important in determining where assets are held. Less liquid bonds may be better suited to strategies with longer term investment horizons, while more liquid bonds may be more appropriate for daily dealing funds. 

Inflows and outflows also shape liquidity management. Large inflows may give managers scope to deploy capital into attractive opportunities. However, if attractive opportunities are not readily available, they may hold cash or invest in more liquid assets until capital can be deployed efficiently. Significant outflows may require managers to determine which assets can be sold without undermining the portfolio’s risk-return profile. 

In our view, liquidity should therefore be viewed as a core component of portfolio construction. A manager adopting a selective and disciplined approach may help a portfolio navigate market headwinds and outflows, while preserving the flexibility to capture attractive risk-adjusted returns when they arise.