Why is liquidity so important?
This part of our series on bond market liquidity as it relates to mutual funds will serve as a quick theoretical detour—like an appetizer before digging into the main course of the day.
“Liquidity” is an appropriate term for describing the concept that we’re discussing because it represents the free flow of orders, akin to water in its liquid state, through markets. Liquidity is crucial for the smooth functioning of markets in that it allows efficient capital allocation—it keeps those who want to make transactions from being stuck.
When liquidity in financial markets declines, we see the following key effects:
- Rising transaction costs. A change in external factors or market structure may lead to a rise in transaction costs for investors.
- Protracted transaction times. A fall in transaction volumes would lead to longer waits for investors to transact on the market in question.
- Rising price volatility. A liquidity squeeze leads to a rise in price volatility as one segment—for buyers or sellers—outnumber the other.
When price volatility rises, there are either too many people trying to sell or buy in a given period. It’s important to note, however, that the logic doesn’t necessarily work the other way around. For instance, not all bouts of volatility indicate a liquidity squeeze.
Measuring liquidity in financial markets
Liquidity in financial markets can be measured in several ways. The following are two of the most popular ones:
- Bid-ask spread. The bid-ask spread represents the difference between the highest price offered by a buyer and the lowest price desired by the seller. A rise in the spread may signal falling liquidity in financial markets.
- Transaction size. In a liquid market, a large transaction should go through without adversely impacting the price of the security being transacted. However, if the size of the transaction falls over a considerable period of time, it may indicate trouble with liquidity because investors are finding it difficult to successfully transact a big chunk of securities in one go.
In the next part of this series, we’ll go back to our main course of the day, bond market volatility (NCOAX) (FMEQX). Investors in high-yield bonds (BERY) (ALLE) (OA), Treasuries, and high-grade corporate bonds should have a lot at stake if liquidity dials down.