Bond Markets

Most individuals purchase bonds via a broker or through bond funds. By the end of this section, you will be able to describe the process for purchasing a bond and explain why bond markets may not have price transparency.

Price Transparency

Since bonds are traded in a decentralized, over-the-counter market dominated by dealers, there can be a lack of price transparency.


LEARNING OBJECTIVE

  • Explain why bond markets may not have price transparency

KEY POINTS

    • A market is transparent if much is known–by many–about what products, services, or capital assets are available at what price and where.
    • In most developed bond markets, such as the United States, Japan, and western Europe, bonds trade in decentralized, dealer-based, over-the-counter markets.
    • Poor transparency contributes to investor differences in bond valuations, as well as other inefficiencies that may lead to economic losses for market participants and, ultimately, inhibit business development.

TERMS

  • transparency

    (figuratively) openness, degree of accessibility to view

  • market liquidity

    In business, economics, or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value.

In economics, a market is transparent if much is known–by many– about what products, services, or capital assets are available at what price and where.

There are two types of price transparency:

  1. Knowing what price will be charged to me
  2. Knowing what price will be charged to you

The two types of price transparency have different implications for differential pricing. Bond markets, unlike stock or share markets, sometimes do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the United States, Japan, and western Europe, bonds trade in decentralized, dealer-based, over-the-counter markets. This convention, combined with the large number of debt issues outstanding, is largely responsible for the lack of price transparency that exists in the fixed income markets.


New York Stock Exchange: Most bonds are not sold in centralized marketplaces, such as the New York Stock Exchange, leading to a lack of price transparency.

Poor transparency contributes to investor differences in bond valuations, as well as other inefficiencies that may lead to economic losses for market participants, and, ultimately, inhibit business development. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterpart to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory". In other words, the dealer holds it for his own account. The dealer is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor–the "bid" price–and the price at which he or she sells the same bond to another investor - the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another. In summary, since bonds are traded in a decentralized, over-the-counter market dominated by dealers, there is a lack of price transparency for bond markets.