Measuring Bond-Level Liquidity

T ransaction cost considerations enter the decision-making process of all participants in fixed-income secondary markets. The timing and size of individual trades are influenced by the trade-off between the cost of trading and the opportunity cost of not trading. Yet, although its importance is recognized, liquidity is not easy to measure.

Academics and policymakers are interested in aggregate market liquidity and use a variety of variables to study or monitor it. Investors, however, are concerned about the liquidity of their portfolios and individual holdings. How does one measure the liquidity of a bond? There has been some success in measuring liquidity in transparent and active equity markets; but in bond markets, it's a challenge because of the sheer number of instruments and the infrequent trading in most of them. Moreover, unlike stocks, which largely trade in exchange-based markets, bonds still trade mostly over the counter. Although some markets (notably USD credit) have regulations requiring that trades be reported, transaction data is scarce in others.

In 2009, Barclays created a bond-level liquidity measure to fill a gap in the bond investor's toolbox. Because of the dearth of transaction data, this measure relies on simultaneous two-way quotes from Barclays' traders who make markets in a significant number of bonds. These are automatically collated, parsed, and saved as part of the Barclays index validation process. On any given day, many more bonds are quoted than traded. bid-ask spreads themselves do not incorporate the market impact of large trades, which is often of interest, but many traders and investors find bid-ask spreads to be sufficiently positively correlated with market-impact costs.

Barclays' bond-level liquidity measure,Liquidity Cost Score (LCS), is defined as the cost of an institutional-size, round-trip transaction; therefore, a lower LCS signifies better liquidity. LCS is expressed as a percentage of the bond's price and can be aggregated across bonds and compared over time. Portfolio managers can use this measure to quantify the liquidity of their holdings and compare them to a benchmark. A consistent quantitative metric facilitates rigorous studies of market liquidity and other market phenomena.

LCS METHODOLOGY

Traders post bid and ask quotes in two different ways: as yield spreads over Treasuries or as bid and ask prices. The former arespread quotes (typical for...