Don't Worry About Liquidity with Bonds Issued in Small Amounts


Individual and institutional investors prize liquidity. If they can easily sell and buy bonds, they're very happy campers. If the bonds they hold are thinly traded, they tend to get rather upset because they may not always be able to dump their bonds quickly and at a good price if interest rates shoot up.

Most bond investors assume that the larger a bond issue is, the more liquidity it has. For example, if Ford issues $500 million worth of bonds at 8 percent, investors believe that those bonds will be more actively traded and therefore more liquid than if Ford were to issue only $50 million worth of bonds at 8 percent.

If investors value liquidity, as they claim, they would pay more for a bond of a bigger issue than for a smaller issue and therefore, the yield of the bigger issue would be smaller than the yield for the smaller issue. Bond prices vary inversely to their yield.

But this is not the case, according to researchers at Merrill Lynch & Co. and Chase Manhattan Bank. They found that corporate bonds, which have an average size of $265 million and medium-term notes, with an average size of $4 million, have the same yields, meaning that "large and small securities issued by the same borrower are close substitutes."

The researchers studied debt issued by General Motors Acceptance Corporation, Ford Motor Credit Company, General Electric Capital Corp. and Merrill Lynch & Co. between 1987 and 1992. After making sure that the larger issue bonds and the smaller issue medium-term notes had the same issuance and maturity date, the researchers found no difference between the yields of the bonds and the medium-term notes. "Liquidity is not a function of issue size," they conclude.

Bottom line: buy bonds on their credit quality, not on the size in which they were issued.

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