The Indian debt market is valued at US$2.69 trillion. The number includes both government and corporate bonds. While government securities (G-sec) account for over 70% of the market, the corporate bond market alone is worth US$602 billion. The corporate bond market expanded by 9% last year, outpacing the overall bond market growth by 2.5%. The corporate debt market is also garnering retail investor interest as it grows.
As the listed corporate bond market matures, the next frontier is clear: improving corporate bond liquidity. While challenges remain, the improvement is unmistakable. With ongoing regulatory reforms, digital platforms enhancing accessibility, and increased retail participation, India’s corporate bond market is well on its way to becoming more liquid, efficient, and investor friendly.
In this blog, we examine what bond liquidity means, how liquid Indian corporate bonds are in practice, and what parameters investors can use to evaluate the liquidity of a corporate bond.
What is Liquidity in Bonds?
For bonds, liquidity is the investor’s ability to sell them in the secondary market at a reasonable price within a fair timeframe. Highly liquid bonds find buyers quickly without a steep discount, whereas illiquid bonds may require a steep discount and longer wait times to attract buyers.
As a general rule, G-secs are more liquid than corporate bonds. This is because G-secs are the safest debt instruments in the country, carrying sovereign guarantee.
Corporate bond liquidity is influenced by several factors, including the issuer’s creditworthiness, maturity, and changes in the bond yield resulting from fluctuations in the country’s interest rates.
Let’s examine whether bonds can be considered liquid assets and how corporate bonds fare on the liquidity spectrum.
Are Bonds Considered Liquid Assets?
Bonds occupy a unique space on the liquidity spectrum. G-secs are considered cash equivalents, meaning they can be converted to cash almost immediately without any considerable loss of value. G-secs experience a high level of daily trading volume, with broad participation and transparent pricing; however, the picture changes when we shift our focus to corporate bonds.
Corporate bonds in India aren’t as liquid as their government counterpart. While listed corporate bonds are available on the secondary market, such as BSE and NSE, for trading, the volume is generally low with limited participation. The liquidity of corporate bonds also depends on factors such as credit ratings, tenure, and repayment structure. For investors, this means that corporate bonds require a discerning eye and more patience.
Therefore, while bonds at large may be relatively liquid, the market depth can differ based on a specific type and issuer. For Indian corporate bonds, liquidity is more conditional than assumed.
Are Corporate Bonds Liquid?
The short answer to the question about corporate bond liquidity is – it depends.
Corporate bond liquidity is somewhat sporadic but is seeing an increase as investor-friendly reforms and technological improvements gain momentum. The increasing presence of online bond platforms is making corporate bonds a household name, increasing retail interest and participation.
While bonds still do not enjoy the same liquidity and volume as equities, bonds issued by blue-chip companies and NBFCs now attract broader base participation and increased trading volume.
According to data from the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI), corporate bond trading volumes have increased over the years. However, a large portion of trading is still dominated by private placements and institutional investors, rather than open-market retail trades.
The good news is that retail participation is on the rise after SEBI reduced the minimum ticket size for corporate bonds from Rs. 1,00,000 to Rs. 1000. This move has lowered the entry barrier for retail investors.
For retail investors, the corporate bond liquidity of investment-grade bonds is decent. Let’s understand the factors that impact liquidity so that you can choose investment opportunities with better liquidity.
Factors That Affect Corporate Bond Liquidity
The corporate bond market is still finding its rhythm. Unlike equities, bonds often lead quieter lives, seeing far lower trading volumes compared to equities. However, the Indian bond market is evolving rapidly, with an increasing number of borrowers tapping the debt market to raise capital. Several key factors shape the liquidity of the corporate bond market in India.
Credit Rating
Credit ratings are a bond’s reputation score. Bond ratings ranging from AAA to BBB are considered investment-grade bonds and thus enjoy higher liquidity compared to speculative bonds. Within the investment-grade spectrum, AAA and AA-rated bonds issued by blue-chip companies with a strong credit reputation tend to enjoy higher liquidity. Liquidity will start to dry up as you transition to high-risk, speculative bonds with a rating of BB and lower.
Maturity Profile
Short-term bonds with a maturity of 5 years or less offer good liquidity, as they provide a lower credit risk while allowing for a quick exit. The lower credit risk attracts retail investors, thereby enhancing market liquidity.
Long-term bonds with maturities of 6 years or more, on the other hand, can prove to be less liquid, as they attract institutional buyers, such as insurance companies and pension funds, that aim to hold the bonds until maturity, which impacts secondary market activity and, consequently, the liquidity of these bonds.
Issue Size
Larger bond issues are more liquid, as they are widely held and frequently traded on exchanges such as the NSE and BSE, compared to smaller bond issues, which may be privately placed to hold-till-maturity investors, thereby impacting secondary market trading activity.
Listing Status
SEBI has mandated the listing of all publicly issued bonds on the NSE or the BSE. Listed bonds enjoy greater visibility compared to their unlisted counterparts and are thus easier to liquidate.
Market Infrastructure
The Indian bond market is undergoing reforms, and the emergence of electronic bond platforms is enhancing liquidity in the bond market. However, the bond market is still not as seamless as the equity markets and can see multiple reforms in the coming time to further ease corporate bond liquidity in India.
While corporate bond liquidity is improving in India, it still has considerable scope to reach the level of liquidity enjoyed by the Indian equity markets. Let’s understand why corporate bond liquidity is essential from the perspective of a retail investor.
Why is Liquidity Crucial for Corporate Bonds?
Corporate bond liquidity plays a crucial role in ensuring the smooth functioning of the debt market in India.
Liquidity refers to the ability to buy and sell bonds in the secondary market within a reasonable timeframe without significantly affecting their price.
Market participants, especially retail investors, are more likely to invest in the bond market when they are assured of an easy exit in case the need arises.
Easy liquidity also makes the issuer’s life easier as it lowers the cost of borrowing. Bonds with perceived liquidity enjoy greater demand, enabling companies to raise capital at favourable rates. Conversely, companies have to offer an illiquidity premium in the form of higher yields to attract investors, ultimately increasing the cost of capital.
Additionally, corporate bond liquidity is also integral to the broader health of the country’s financial architecture. A wider, liquid bond market offers an alternative to the traditional banking system, diversifying the sources of capital available to businesses for raising funds. The ease of borrowing, in turn, supports economic growth while also enhancing financial stability.
How to Assess Corporate Bond Liquidity
Not all bonds are equal. When it comes to corporate bond liquidity, investment-grade bonds issued by blue-chip borrowers enjoy the highest liquidity, while speculative bonds have more patchy liquidity. Here is how you can assess corporate bond liquidity to make an informed investment decision:
- Trading Volume and Frequency
Bonds are listed on exchanges to provide investors with a means to liquidate their investments before the redemption date. Listed bonds that trade regularly on exchanges such as the NSE or the BSE are more liquid compared to bonds that see bleak trading volumes.
- Bid-ask Spread
The bid-ask spread is the difference between the selling price (bid) and the buying price (ask). You would typically want to invest in bonds with a narrow bid-ask spread, as it indicates higher liquidity.
- Credit Ratings
Credit ratings indicate the borrower’s repayment ability. The higher the ratings, the safer the bond and vice versa. Bonds with higher ratings are perceived as safer and thus more liquid compared to riskier, speculative bonds.
- Issue Size and Maturity Profile
Larger bond issues tend to be more liquid owing to a broader investor base compared to smaller issues, which can be closely held. Additionally, bonds with shorter maturities also tend to be more liquid than bonds with long and ultra-long tenures. This is because shorter-maturity bonds present lower interest rate risk, making them more attractive.
As an aspiring bond investor, you can evaluate the bonds on these parameters to identify corporate bonds with decent liquidity for your portfolio.
Understanding Liquidity Risk in Bonds
Liquidity risk in investments arises from the inability to convert the investment to cash without incurring a loss in value when needed. When it comes to bond investments, the Indian secondary bond market is not as liquid as the Indian equity market.
Most bond investments in India are held until maturity. This curbs secondary market liquidity, as trading volumes are low. Additionally, Indian bond investments are concentrated in high-rated investment-grade bonds. This hampers the trading volumes of speculative bonds.
As an Indian bond investor, you might face some degree of liquidity challenge in corporate bonds, and might have to wait for a few days to turn your investments into cash. Therefore, it is recommended that you don’t park your first line of emergency funds into corporate bonds. However, corporate bonds make a great addition to your portfolio, as they often provide inflation-beating returns while helping you generate a regular income. As an investor, you can use the following investment strategies when adding corporate bonds to your investment portfolio.
Strategies to Manage Liquidity Risk in Bond Investing
Risk and returns are inextricably linked. This is as true for bond investments as it is for equity investments. Here is how you can manage liquidity risk associated with corporate bond investments:
- Investment Diversification
Diversifying bond holdings across industries, issuers, credit ratings, and tenures can help you hedge liquidity risk, as all bonds enjoy different liquidity profiles. You can add short to medium-term bonds for enhanced liquidity and long-term bonds to lock in higher yields. Optimal diversification will help you build a well-balanced corporate bond portfolio, striking a balance between yields and liquidity.
- Focus on Investment Grade Bonds
High-rated bonds have consistent demand in the market. This makes them liquid. Focusing on investment-grade bonds will ensure easy liquidity if and when needed.
The Bottom Line
Liquidity impacts your ability to encash your investments. Corporate bond liquidity is about investors being able to sell the bond on the secondary market at a reasonable rate without incurring a loss in value.
While the secondary bond market in India is still in its development phase, corporate bond liquidity management is relatively straightforward. You can evaluate the liquidity profile of a bond based on parameters such as the credit rating of the issue, maturity profile, and issue size. You can build a diversified bond portfolio based on your evaluation to hedge the liquidity risk while also locking in high returns.
FAQs related to the Liquidity of Bonds
What makes a corporate bond liquid or illiquid?
The liquidity of a corporate bond is determined by its trading volume and frequency, and can be influenced by factors such as credit rating, issue size, and maturity profile.
How does liquidity impact bond prices?
Highly liquid bonds usually trade at tighter spreads and better prices due to the ease of buying and selling. Illiquid bonds often require a yield premium, meaning issuers must offer higher interest to attract investors.
Are government bonds more liquid than corporate bonds?
Yes, government bonds are generally more liquid than corporate bonds.
What are the best ways to measure bond liquidity?
Corporate bond liquidity can be assessed using metrics such as trading volume, bid-ask spreads, transaction frequency, and the time it takes to execute a trade.
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