As a new investor, one of the concepts you’re likely to hear about often is “liquidity”. This term is an important one and if you take the time to understand why it’s important, it can make or cost you a lot of money. This is especially true if you invest in bonds. Due to the way the bond market is structured, the low liquidity in some bonds can actually cost you tens of thousands of dollars when buying or selling investments.
Understanding Market Liquidity and How It Can Cost You Money
When it is really easy to find a buyer or seller for a specific asset, it is said to have a lot of liquidity. The harder it is, the less liquidity it has. Some of the most liquid investments in the world are shares of giant blue chip corporations in the United States such as General Electric, Wal-Mart, or Johnson & Johnson. Today, for instance, 71,625,404 shares of General Electric traded hands, representing approximately $832,287,194. Unless you are on the Forbes list, that means you could have bought or sold your position in virtually a few seconds due to the extremely high liquidity.
The trading of these shares is helped by someone called a market maker. Basically, a market maker works on the floor of a stock exchange and literally creates a market for the buying and selling of shares. That way, if I want to sell 1,000 shares of GE at 12:01 p.m. and you come along to buy at 12:03 p.m., the market maker uses his firm’s money to buy my shares and keeps them in inventory until you show up, selling them once your order comes through the system. Otherwise, I’d have to sit and wait until your order was entered and the market would function a lot less effectively.
The stock exchange allows the market maker to charge a “spread” because they are risking their money. If the world fell apart in those two minutes, the market maker is on the hook because they legally own the shares. The profit, in many cases, is only a few cents. If you sell your shares for $12.00 for instance, I may actually pay $12.01 with the market maker taking the $0.01 cut per share. The more liquid the asset, in this case a stock, the less risk the market maker has because he should be able to sell his “inventory” in a matter of a few seconds. If the stock were thinly traded, perhaps a small candy company that only trades $200,000 worth of shares a day, the spread could be much, much larger.
The Bond Market Has Huge Spreads
With a few exceptions, most bonds aren’t listed on an exchange. They trade hands, through a network of dealers, much like a painting would. If you want a certain type of bond, you are going to have to work with your broker to track down someone who has it available for sale, if you can find it at all. Instead, you’re likely to look over a list of available issues from your brokerage firm and select the ones most appropriate to you. It’s a very different world than stocks.
This lack of liquidity means that bonds have very large spreads and that you don’t actually know what your broker made on the transaction. You may pay, say, a $50 trading commission but your broker may charge you $24,500 for a bond they paid $24,000, making an additional $500 on the “spread”.
The implication of this should be clear: If you rapidly buy and sell bonds, you are going to get absolutely creamed on the spreads. Even if the bonds barely change value, after a few transactions, you’d be thousands of dollars in the red because of the spread costs. That’s why it’s even more important than usual that your bond investments be long-term investments, not frequently traded.
