FINRA issued a new Investor Alert regarding bond liquidity, providing investors with a basic overview on how bonds are bought and sold, and factors that may influence bond liquidity and its impact on investment gains or losses.
For instance, bond liquidity is affected by market breadth, dealer inventory and selling pressure. The market includes corporations, municipals and Treasury-issued bonds, which each carrying their own characteristics and degrees of risk.
Many firms are not buying or holding as many bonds as in the past as they look to reduce their risk, which may in turn lead to fewer buyers and sellers in the marketplace. If there are fewer transactors, this could have an adverse effect when it comes time to sell a bond. If there are more investors selling the same bond at the same time, liquidity and profitability could be reduced, which may also result from not as many buyers looking to purchase a particular bond.
Most bond transactions involve a brokerage firm acting as principal in which the broker-dealer sells a bond the firm already owns. These sales may come with a firm-imposed mark up, which increases the purchase price the investor pays over the lower price the firm paid to first buy the bond. In a similar vein, the firm may impose a mark-down when an investor wishes to sell back the bond, which also decreases investor earnings. Firms may also elect to buy-and-hold bonds, which assumes the risk that a buyer will show up at a later time.
Another fee the firm may impose is a commission, which occurs when the firm acts as an agent on behalf of an investor in buying or selling the bond.
The alert from FINRA's Investor Education department suggests that investors consider five key questions before deciding to purchase or sell bonds with a firm:
1. How does the firm handle bond trades and sell orders? If the firm offers a full-service bond desk, it may be better posited to commit firm money to purchase bonds. If the brokerage subscribes to an electronic bond trading platform, it may be better able to find liquidity upon selling bonds.
2. How often has the specific bond traded recently? Bonds that trade more frequently often have more potential buyers and thus greater liquidity than bonds that trade less often.
3. What is the price range of this recent trade activity? Too much volatility or too much of a price swing in a large range may make it more difficult to trade the bond due to its unpredictability, or increase trading costs due to risks associated with such volatility.
4. Does the firm offer any fixed income analysis or other tools that could help model or predict the impact of interest rate fluctuations on bond values? These predictive measures could come in handy if interest rates change, as there is a good chance this will have an impact on bond values.
5. What would a bond portfolio that meets my personal liquidity needs look like? Short-term and long-term goals correspond to securities such as bonds that can be matched to meet those specific goals.
One of the best ways to understand the costs of the bonds business is to research the bonds' supplementary materials, such as the bond circular, information sheet, or other official statements produced by the bond or firm, including those that delineate a firm's procedures for mark-ups and downs and fees or commissions. A broker or advisor is obligated to review such materials prior to making a recommendation. If you have a broker or advisor, ask him or her whether they reviewed the materials and what they found. Disclosures or subsequent updates may be valuable in evaluating liquidity risk, which often changes over time in response to market conditions, supply, and similar variables. Again, asking your broker or advisor whether you should continue holding a bond is a good idea. Under the new FINRA suitability rule, a broker's advice to hold is considered a recommendation, one that requires the broker to inform him or herself of the new information before making any such recommendation to hold.
If you have invested with a broker, financial adviser, or firm whose failure to adequately disclose liquidity risk associated with bond transactions, or whose mark-ups, mark-downs, commissions or other fees were excessive and in contravention to written policy or memoranda, and such misconduct has proven harmful to your investments or interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for investigation and consultation.
Investor Alert: Bond Liquidity—Factors to Consider and Questions to Ask (FINRA)