A:

Like stocks, after issuance in the primary market, bonds are traded between investors in the secondary market. However, unlike stocks, most bonds are not traded in the secondary market via exchanges. Rather, bonds are traded over-the-counter (OTC). There are several reasons why most bonds are traded OTC, but chief among them is their diversity.

Stocks have only two types, common stock or preferred stock, and are limited to few characteristics. Bonds on the other hand, have different qualities, maturities and yields. The outcome of this diversity is more issuers, and issues of bonds with different characteristics, which makes it difficult for bonds to be traded on exchanges. Another reason why bonds are traded over the counter is the difficulty in listing current prices.

Stock prices are affected by news events, the P/E ratio of a company and, ultimately, the supply and demand of shares, which are reflected in the daily stock price. In contrast, bond prices are affected by changing interest rates and credit ratings. Since trade time between issues can last weeks or even months, it is difficult to list current prices for a particular bond issue, which would make it challenging to trade bonds on the stock market (For information regarding bond pricing mechanisms, see Understanding Bond Price/Yield Duo.)

What Kinds of Bonds Are Commonly Traded Over-the-Counter?

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. 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).

Why OTC Transactions Can Be Seen As Controversial

Many analysts and pundits claim that over-the-counter (OTC) transactions and financial instruments, especially derivatives, increase systematic risk. In particular, concerns about counterparty risk grew following the financial crisis of 2007-2009, when credit-default swaps in the derivatives market received much of the blame for massive losses in the financial sector.

Transactions in financial markets are either organized in exchanges, such as the New York Stock Exchange and Nasdaq, or occur over-the-counter. An OTC trade is executed directly between two parties and is not overseen or subject to the rules of major exchanges. These off-exchange trades incorporate all of the types of assets seen in exchanges, including commodities, equities and debt instruments.

Derivatives can be made of any asset and only represent contracts based on the value of underlying financial assets. Futures contracts, forward contracts, options and swaps are all derivatives. Derivatives trading makes up a large part of global markets and is increasingly prevalent due to improvements in computing technology.

The controversy about OTC transactions centers around a lack of oversight and information. Major exchanges have a large incentive to control and regulate trades that occur on their watch. OTC traders watch out for themselves to a greater degree. That said, the risk of financial loss is very real on exchanges as well, and there is no guarantee exchange trading is less risky than OTC trading.

Overall, OTC transactions do not have the same rules about contract enforcement as most exchanges. The risk of a party failing to live up to its contractual obligations is often called counterparty risk, although it may sometimes be referred to as default risk. While counterparty risk exists in any contract, it is perceived as a larger threat when the contracts are made over-the-counter.

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