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Sometimes It Costs Money to Sell a Lot of Bonds

Is the bid-ask spread for new bond issues indicative of a conspiracy by dealers? Perhaps it's just a necessary, and reasonable, cost of functioning bond markets.

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One basic fact about markets is that if there are 1,000 widgets in the world, and the “fair” price of a widget is $100, and you need to sell 200 widgets in an afternoon, you will probably get less than $100 per widget for them. Likewise, if you need to buy 200 widgets in an afternoon, you’ll probably pay more than $100 per widget. If you need to do anything, you’ll pay. Financial markets are good at identifying need and extracting value from it.

You can give various names to this phenomenon, but one sometimes useful way to think about it is as “bid-ask spread.” The fair price for a widget is $100. If you need to sell a widget right now, some intermediary will let you sell immediately, but will charge you a bit for that service. Say you’ll get $99.90 for your widget. If you need to buy a widget right now, you will also be charged for immediacy, and pay maybe $100.10. Sometimes you’ll want to buy and I’ll want to sell at exactly the same time, and we’ll trade with each other at exactly $100, but, especially in a market where widgets don’t trade all that often, that coincidence will be rare. Mostly we will both pay for immediacy.

If you need to sell 200 widgets all at once, the odds that I will also need to buy 200 widgets at exactly the same time are low. In fact the odds are low that anyone will need to buy that many widgets in, like, a week. So you’ll pay even more, as a percentage of “fair value,” for immediacy. Perhaps you’ll sell your widgets for $98 each, instead of $100. That $2 per widget surcharge is the price you pay for getting a whole lot of immediacy.

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