Fixed Income Investments - Liquidity Risk
Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.
- Liquidity refers to how deep or liquid the market is for a particular security. If the market is deep, an investor can purchase or sell a security at current prices. If the market is not liquid, it is harder to sell or buy a security at the last market price.
- Liquidity is typically measured by the bid/ask spread. If the spread is wide, the market is illiquid. If the spread is narrow, the market is more liquid.
- Liquidity risk is important because it tells you how easily you can get rid of a position if you need to close it near the last market price.
- This is even more important if you plan to hold a security to maturity because of the marking to market of your positions. In an illiquid market, it may be hard to obtain quotes, and when you revalue the security it could be well below market prices, affecting the reports you send to clients and management.
- This risk also changes over time, so a manager has to keep abreast of this risk. This is especially true when looking to invest in new complex bond structures.