Investors in bonds also face liquidity risk. This is the risk that the investor may have to sell the bond at a price lower than the expected price. Based on the market conditions and also on a review of recent market transactions, the investor can get an idea of the indicative price at which he will be able to sell his security. But when he approaches a dealer/broker and gets a lower rate than what he expects, it’s due to lower liquidity in the particular instrument.
Let’s review some important points about liquidity risk in bonds:
- Liquidity risk is measured using the bid-ask spread. Bid price is he price at which a dealer will buy the security from the investor, and ask price is the price at which the dealer will sell the security to the investor. For instruments having high levels of liquidity, the bid-ask spread will be very small and will not be affected by the size of the transaction. However, as liquidity deteriorates, the bid-ask spread widens.
- Since it’s a dealers market and every dealer offers its own bid-ask quote, different people may interpret liquidity differently. A good way is to compare quotes from different dealers and select the best bid price (lowest) and best ask price (highest). This is referred to as the market bid-ask spread.
- For investors holding the bond till maturity but not marking their position to market, liquidity risk is not very important.
- For investors who are required to mark their position to market (such as mutual funds), liquidity risk is of concern, as the bid price will change. To mark a position to market the investor may take quotes from many dealers and then use the best bid price as the new price for the position.
- For instruments that are very illiquid, the investor may not be able to rely on a quote from the dealer. Instead he will use models to estimate the fair value of the instrument.
- As market conditions change, bid-ask spread may change over time. Changing market conditions may also change impact liquidity and widen bid-ask spread as investors wait before taking new positions.
- The market for new products may be less liquid initially but the liquidity may improve as more brokers/dealers take interest in these products.