FRM Exam Part I · Corporate Bonds

Corporate Bond Market Liquidity, OTC Trading and Bid-Ask Spreads

Updated 11 October 2026 · Fact-checked

Corporate bonds trade mostly over the counter, with dealers quoting a bid and an ask. The bid-ask spread is the cost of immediacy and is wider when liquidity is poor. Liquidity is weakest for small issues, long maturities, high yield and distressed bonds. To solve questions, compute the spread, then its cost or its effect on price.

Understand Corporate Bond Markets and Liquidity

A corporate bond is a debt security issued by a company. After it is issued in the primary market, investors trade it in the secondary market. Unlike stocks, most corporate bonds do not trade on a central exchange. They trade over the counter (OTC), meaning you deal with a dealer, usually a bank, by phone or electronic platform.

Dealers act as market makers. They quote a bid (the price at which they buy from you) and an ask or offer (the price at which they sell to you). The ask is above the bid. The gap is the bid-ask spread. It pays the dealer for holding inventory, for the risk that the price moves, and for the cost of finding a counterparty. You pay half the spread each time you trade, so a round trip costs the full spread.

There are thousands of bond issues, and many seldom trade. This is why corporate bond liquidity is thinner than for government bonds or equities. Spreads widen when issue size is small, the bond is old (seasoned and held by buy-and-hold investors), maturity is long, or credit quality is low. They also widen in stress, when dealers cut inventory and become reluctant to take risk. Liquidity risk is the risk that you cannot sell quickly without accepting a worse price. Part of a bond's credit spread over a Treasury or swap curve compensates for this, not only for default risk.

Investment grade (IG) bonds are rated BBB-/Baa3 or higher. High yield (HY) bonds, also called speculative grade or junk, are rated below that. HY bonds pay higher coupons for higher default risk, are less liquid, and have prices that behave more like equities. A fallen angel is a bond that was IG at issue and is downgraded to HY. This can force selling, because some investors are restricted to IG holdings. A rising star moves the other way.

Distressed debt is debt of a firm that is in or near default, often trading at a deep discount to face value. Its price depends on expected recovery in restructuring or bankruptcy rather than on interest rates. Distressed investors, such as hedge funds, buy it to profit from recovery or to gain influence in a restructuring. Liquidity is thin and spreads are wide.

Key formulas to remember

Bid-ask spread (absolute): Spread = Ask − Bid; Quoted in price points per 100 of face value or in currency.
Percentage (relative) spread: Relative spread = (Ask − Bid) ÷ Mid-price; Mid-price = (Ask + Bid) ÷ 2. Use it to compare bonds with different price levels.
Cost of a trade: One-way cost = ½ × Spread × Face value ÷ 100 (price quoted per 100); A round trip (buy then sell at unchanged quotes) costs the full spread.
Price impact of a yield spread: ΔPrice ≈ −Modified duration × Δyield × Price; Use it to turn a yield bid-ask into a price bid-ask. Higher yield is lower price.
Credit spread decomposition: Credit spread ≈ Expected default loss + Liquidity premium + Risk premium; A conceptual rule, not an exact identity. Illiquid bonds carry larger liquidity premiums.
Rating boundary: IG: BBB-/Baa3 and above; HY: BB+/Ba1 and below; S&P and Fitch use BBB-; Moody's uses Baa3.

How to solve Corporate Bond Markets and Liquidity questions

Use this method for any question on corporate bond markets, spreads or liquidity.

1Identify what is asked: a cost, a price, a qualitative liquidity driver, or a classification (IG, HY, fallen angel, distressed).
2Note whether quotes are prices (per 100 face) or yields. If yields, convert the yield difference to price using duration.
3Find the bid and ask. Remember you sell at the bid and buy at the ask.
4Compute the spread = Ask − Bid, and the mid-price if a relative spread is needed.
5Scale to the position size: face value ÷ 100 × price points. Halve it for a one-way cost, use the full spread for a round trip.
6For qualitative questions, link the feature (small issue, low rating, stress, long maturity) to dealer inventory risk and a wider spread.
7Check the sign and size: the ask must exceed the bid, and the cost should be small relative to the position.

Quickest way: Spread first, then scale

When to use it: Use when the question gives bid and ask prices and a position size.

Write Ask − Bid in price points.
Multiply by face value ÷ 100.
Halve it if the question says one-way or 'cost versus mid'.
For qualitative options, pick the answer where less liquidity means a wider spread and a higher required yield.
Eliminate options that say HY bonds are more liquid or that dealers reduce spreads in stress.

Common mistakes in Corporate Bond Markets and Liquidity

Treating the full bid-ask spread as the cost of one trade.
The spread is the headline number, so it is applied directly.
Fix: One-way cost versus mid is half the spread. Only a buy and sell round trip costs the full spread.
Buying at the bid or selling at the ask.
The quotes are written from the dealer's side, which is easy to reverse.
Fix: The dealer buys at the bid and sells at the ask. You sell at the bid and buy at the ask.
Assuming corporate bonds trade on exchanges like stocks.
Equity market structure is more familiar.
Fix: Most corporate bonds trade OTC through dealers. Exchange trading is the exception.
Treating the entire credit spread as compensation for default risk.
Credit spread is taught alongside expected loss.
Fix: Spreads also include a liquidity premium and a risk premium. Illiquid bonds show wider spreads than their default risk alone implies.
Confusing fallen angels with distressed debt.
Both involve falling credit quality.
Fix: A fallen angel is a downgrade from IG to HY. Distressed debt is of a firm in or near default, often at a deep discount. A fallen angel need not be distressed.
Forgetting that yield and price move in opposite directions when converting a yield spread to price.
Mixing the bid yield and the bid price.
Fix: The bid price corresponds to the higher yield and the ask price to the lower yield.

Worked examples

Example 1

A dealer quotes a corporate bond at 98.40 bid and 98.90 ask per 100 face value. You buy ₹5,00,00,000 face value at the ask and, with quotes unchanged, sell it back immediately. What is the round-trip cost?

Show the solution

Spread = Ask − Bid = 98.90 − 98.40 = 0.50 points per 100.
Position in units of 100 face = ₹5,00,00,000 ÷ 100 = ₹5,00,000.
Round-trip cost = 0.50 × ₹5,00,000 = ₹2,50,000.
Check: you pay 98.90 and receive 98.40, a loss of 0.50 per 100, which is 0.5% of face value, about 0.51% of the price.

Answer: ₹2,50,000

Example 2

A bond has a bid price of 99.20 and an ask price of 99.80. Its modified duration is 5.0. What is the relative bid-ask spread, and what is the approximate yield difference between the bid and the ask?

Show the solution

Spread = 99.80 − 99.20 = 0.60.
Mid-price = (99.80 + 99.20) ÷ 2 = 99.50.
Relative spread = 0.60 ÷ 99.50 = 0.00603, about 0.603%.
Yield difference ≈ Spread ÷ (Duration × Mid-price) = 0.60 ÷ (5.0 × 99.50) = 0.60 ÷ 497.5 = 0.001206.
So the yield difference is about 0.12%, or about 12 basis points. The bid yield is the higher one.

Answer: Relative spread ≈ 0.60%; yield difference ≈ 12 basis points

Exam tips

Know the direction of every liquidity driver: smaller issue, lower rating, longer maturity, older bond and market stress all widen spreads.
Always check whether the question wants a one-way or round-trip cost, and whether you are buying or selling.
Be ready to define fallen angel, rising star, high yield and distressed debt in one line each, since options often differ by one word.
If yields are quoted, convert with modified duration and keep the price-yield inverse relationship in mind.
On a calculator, store the spread in memory and multiply by the position size to avoid decimal slips.

Practice questions from Corporate Bonds

Corporate Bond Markets and Liquidity in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Corporate Bond Markets and Liquidity: frequently asked questions

Why do corporate bonds trade over the counter?

There are very many issues, each with a small amount outstanding, and most are held to maturity. Centralising them on an exchange would give few trades per bond. Dealers can match buyers and sellers individually and hold inventory, so OTC dealing is the norm.

What is the difference between high yield and investment grade bonds?

Investment grade bonds are rated BBB-/Baa3 or higher and have lower default risk. High yield bonds are rated below that, pay higher yields, are less liquid and are more sensitive to the credit cycle and equity markets.

What is a fallen angel?

A fallen angel is a bond that was investment grade when issued and has been downgraded to high yield. Investors restricted to investment grade may be forced to sell, which can push prices down and spreads up around the downgrade.

What is distressed debt?

It is debt of an issuer that is in or near default, trading at a deep discount to face value. Prices reflect expected recovery in restructuring or bankruptcy. It is illiquid, with wide bid-ask spreads, and is usually bought by specialist investors.