Liquidity, in financial terms, measures how quickly an asset may be turned into cash with a minimal loss of value. The United States is blessed with a broad, deep, liquid stock market. Several factors contribute to the nature of the stock market, perhaps most important among them are competition, regulation and the fact that for every investable company there is, in the vast majority of cases, only one security.
For example, if you are interested in selling 250 shares Exxon, there is only one stock that can fulfill that interest, Exxon. Its ticker symbol is XOM and it is traded on the New York Stock Exchange. Because of competition you know that when you place your order to buy XOM you will get it at the next price for a small fee.
Trading in US stocks for all investors has never been easier. At least for now, trading stocks requires an intermediary, or broker. Sell and buy orders are matched electronically and your order to sell 250 shares happens almost instantaneously at the last price. In Figure 1, the trading fee for matching the trade is 2 cents a share. This number was 35 cents a share before 1975! Selling 250 shares of XOM is pretty liquid; For .03% of your cash, you get what you want. The same is true for literally thousands of other stocks traded on US exchanges.
As we consider financial assets other than United States stocks, liquidity characteristics change. The United States Bond Market is also broad but not as deep. Unless you have a lot of money invested in a single bond, you will find that you can sell your bond quickly but with a more material loss of value. Imagine you own 20 XOM bonds, with a 2.73% coupon, maturing in 2023. The price of each bond looks to be $98.49. When you place an order to sell your bonds you will most likely not get $98.49 for them.
Bonds are issued by companies, municipalities, or governments at various times over the course of their life cycles. Each bond has characteristics that are right for the time of issuance but may be less right at different times. As Figure 2 shows, Exxon currently has 19 bonds outstanding with a diverse set of coupons, maturities, and more.
When you want to sell your 20 bonds, a broker will consider how likely it is that she can find an entity to buy your bonds. In finance speak, that is referred to as ‘finding the other side’. In doing so, the broker factors in a charge. Each broker contacted will suggest a price at which it would buy your bonds from you.
The broker discounts the price you can see to one which gives her a cushion and maybe some profit to complete the trade. Until the broker finds the other sider she holds them herself, or adds them to her inventory. Some bonds get bigger discounts than others. In our example, the best price you actually received was $96.50 per bond, not $98.49. The implied charge as shown in Figure 3 for ‘finding the other side’ amounts to $398.80 or two percent (2%).
With respect to bonds, size matters. According to a recent study, the larger the amount of any bond you have to sell, the less of a charge from the best broker bid. Take a look at the chart below:
Reading the chart from left to right, you can see that your 20 bonds, or $19,000 worth, would ‘cost’ about 2% to sell. If you had 2,000 bonds, or about $2,000,000, your ‘cost’ is only .11%, very close to the fee to trade a US stock.
Most of us do not have a million or two dollars in a bond to trade most of the time. Fortunately, there is a convenient, efficient remedy: a mutual fund.
Established Mutual Funds can be sizable yet nimble, investing billions of client monies on their behalf. In doing so, they routinely deal in bond lots of one or two million dollars or more and receive the best possible net price. In addition, each day after market close, each mutual fund has its assets marked to market and a verifiable net asset value (NAV) is established. When you want to sell your shares in your mutual fund you get today’s NAV. Immediate and with no loss of value. The definition of liquid.
On your behalf we plan to invest cash earmarked for fixed income in appropriate mutual funds for reasons we have highlighted. In addition, we will be researching a more robust asset allocation solution that would include fixed income and other asset ‘classes’. Our plan is to use mutual funds to efficiently reach those financial assets as well. Stay tuned. We will be reviewing asset allocation ideas and maybe expand a little on mutual funds as a topic in the near future.