Credit Derivatives: Trading, Investing and Risk Management, Second Edition

4

Liquidity, the Credit Pyramid and Market Data

4.1 BOND LIQUIDITY

We are used to looking at a government bond spread curve and seeing a sensible pattern - yields on bonds of different maturities follow a smooth curve (or surface) driven by maturity (and coupon, for example). A few bonds are special on repo and have yields that do not lie on the surface but are explained by this additional factor.

Credit bonds and loans generally do not trade in the same volumes as government bonds - they are less ‘liquid’. Figure 4.1 shows (maturity) spreads on British Telecom EUR large denomination issues (more than EUR500m) - large and supposedly liquid issues on one of the most heavily traded credit names. Even here the pattern of spreads is not as smooth as we would expect and the deviations cannot be ascribed to repo, seniority or other independently measurable factors. Such differences are usually ascribed to ‘liquidity effects’ or ‘illiquidity’.

The situation is worse if we move away from the major borrowers. Many companies only have one or two bonds in issue. One may trade regularly and the other may trade rarely. Even if the maturities are similar, an investor would prefer the bond that trades regularly because it is then relatively easy to dispose of at a fair price, and there is also a transparent market which allows the valuation of this asset. How much cheaper (wider spread) should the other bond be? There is no straightforward answer to this question.

Bonds in issue are often ...