Why are corporate bonds typically traded OTC

Why are most bonds traded "over the counter" on the secondary market?

Like stocks, after issue on the primary market, bonds are traded between investors on the secondary market. However, unlike stocks, most bonds are not traded on the secondary market on exchanges.

Rather, bonds are traded over the counter (OTC). There are several reasons most bonds trade OTC, but the main one is their diversity.

The central theses

  • Unlike stocks of a company that is traded on exchanges, most corporate bonds are traded over the counter (OTC).
  • This is because bonds come from several different issuers and each issuer is offered several bonds - with different maturities, coupons, face values ​​and credit ratings.
  • Since they are not listed on major exchanges, in many cases investors need to turn to their brokers to arrange the buying and selling of bonds.
  • OTC markets tend to be less regulated, less transparent, and less liquid than exchange-traded securities, which increases transaction and counterparty risk.

Stocks versus bonds

Before we look at the bond market, let's look at how stocks are typically traded. Stocks are of two main types, common or preferred, and are limited to a few characteristics.

Bonds, on the other hand, each have different qualities, terms and yields. The result of this diversity is more issuers and issues of bonds with different characteristics, which makes it difficult to trade bonds on exchanges. Another reason bonds are traded over the counter is because of the difficulty of listing current prices.

Stock prices are affected by news events, a company's P / E ratio, and ultimately the supply and demand of stocks, which is reflected in the daily stock price.

In contrast, bond prices are affected by changing interest rates and credit ratings. Since trading time between issues can be weeks or even months, it is difficult to give the current prices for a particular bond, which would make it difficult to trade bonds on the exchange.

What types of bonds are typically traded over the counter?

Most corporate bonds issued by private and public corporations are traded OTC and not listed on the stock exchanges. In addition, many transactions in exchange-traded bonds are conducted through OTC markets.

Corporate bonds are issued by companies to raise capital to fund various expenses. They are attractive to investors because they offer much higher returns than government-issued bonds. However, this higher yield is associated with a higher risk. Corporate bond investments come primarily from pension funds, mutual funds, banks, insurance companies, and individual investors.

The bonds that trade on the OTC markets differ in the liquidity they have. Liquidity gives investors ample opportunity to buy and sell bonds at fair prices before they mature. Along with this liquidity, OTC-traded corporate bonds offer investors a steady stream of income and securities as they are valued based on the issuer's credit history.

However, these bonds are not perfect investments and carry great risks such as credit risk and call risk. Credit risk can arise if an issuer is unable to maintain payments on the bond or if a rating company lowers the issuer's creditworthiness. Call risk arises when an issuer repays the issue before maturity and offers the investor less favorable investment opportunities.

Why OTC transactions can be considered controversial

Many analysts and experts claim that over-the-counter transactions and financial instruments, especially derivatives, increase systematic risk. In particular, counterparty risk concerns increased after the 2007-2009 financial crisis, when credit default swaps in the derivatives market took a large portion of the blame for massive losses in the financial sector.

Transactions in financial markets are either organized on exchanges such as the New York Stock Exchange and the Nasdaq, or over the counter. An OTC trade is carried out directly between two parties and is not monitored or subject to the rules of the major exchanges. These over-the-counter trades encompass all types of assets found on exchanges, including commodities, stocks, and debt.

Derivatives can be made from any asset and are only contracts based on the value of the underlying financial assets. Futures contracts, forward contracts, options and swaps are derivatives.5 Trading in derivatives makes up a large part of global markets and is becoming increasingly common due to improvements in computer technology.

The controversy surrounding OTC transactions has centered on a lack of control and information. Large exchanges have a great incentive to control and regulate trades that take place on their watch. OTC traders are paying more attention to themselves. However, the risk of financial loss is very real even on the stock exchanges, and there is no guarantee that trading on the stock exchange will be any less risky than trading OTC.

The bottom line

Overall, OTC transactions do not have the same contract enforcement rules as most exchanges. The risk that a party will fail to meet its contractual obligations is often referred to as counterparty risk, although it can sometimes be referred to as default risk. While there is counterparty risk in every contract, it is seen as a greater threat when the contracts are entered into over the counter.