Can a bond be traded over-the-counter?

A:

Bonds can be traded over-the-counter (OTC) and, in fact, the majority of corporate bonds that are issued by private and public corporations are traded OTC rather than on exchanges. Furthermore, many of the transactions involving exchange-traded bonds are done through OTC markets.

Corporate bonds are issued by firms to raise capital to fund various expenditures. They are attractive to investors because they provide much higher yields than bonds issued by the government. However, this higher yield is accompanied by higher risk. Investment in corporate bonds comes primarily from pension funds, mutual funds, banks, insurance companies and individual investors.

The bonds that are traded on the OTC markets are most beneficial in the liquidity that they provide. According to the Bond Market Association, total bond issuance for 2005 reached $5.52 trillion and new corporate bond issuance was $678 billion. This liquidity provides ample protection for investors looking to sell bonds before maturity. Along with this liquidity, corporate bonds traded OTC provide a steady stream of income and security because they are rated based on the credit history of the issuing firm. (For further reading, see What Is A Corporate Credit Rating?)

However, these bonds are not perfect investments and they include major risk, such as credit risk and call risk. Credit risk can arise when an issuer is unable to maintain payments on the bond or if the credit rating of the issuer is lowered by a rating corporation. Call risk arises when an issuer redeems the issue before maturity, leaving the investor with less favorable investing possibilities.

For more information, see our Bonds Basics tutorial and Corporate Bonds: An Introduction to Credit Risk.

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