Understanding Liquidity Risk

If you are involved with bonds and you are still wanting to learn the basics, liquidity risk is something you're going to want to learn about. It's not something you need to know for investing but is handy when you want to understand the details. Stick to the causes of liquidity risk that will help you gain a deeper understanding of how and why professionals discuss it.

Liquidity risk is essentially the risk entailed with a lack of liquidity in the markets. This normally happens where there are markets that are scantly traded. Be aware that this risk is not too much of a concern for the average investor. This is due to the fact that market makers provide a built-in liquidity premium. The more liquidity risk there exists, the more liquidity premium there should be.

Applying this basic principle to bonds introduces the liquidity preference theory. This theory says ultimately that the bonds that are preferred are the most liquid ones. Since the most liquid bonds are the near-term maturities, such as the Treasury bills or U.K. gilts, these are the ones with the highest liquidity. Note also that, as time until maturity increases, the liquidity risk also increases. As mentioned before, this liquidity risk is normally compensated with a risk premium.

The types of liquidity risks could stem from the following: bid and ask spreads and low proportion of buyers and sellers.

Bid-Ask Spread

Look at the bid-ask spread to see what it is telling you. It could say a lot of things, but know for sure that when the bid-ask spread is tight, the risk is very low. And when the bid-ask spread moves sporadically, like leaves in the wind, then you should really start to worry about the liquidity risk. That all goes back to the concept of volatility, and volatility, you must remember, is one of the causes of risk. You can look at it as though it's a scientific corollary or just know that the markets are going to take it for a cause and so should you. All in all, you should be wary of the bid-ask spread.

Buyers and Sellers

Investing in bonds is not like investing in stocks. Think of what happened during the mortgage bond crisis of the late 2000s. It was one of the most voluminous chains of events in financial history. This is because the mortgage bond and CDOs (collateralized debt obligations) market was one of the largest markets in the world, monetarily speaking. It was even bigger than the Treasury market. Yet the market capsized because, when times got risky, the pools of investors all wanted to exit at the same time, and there was a serious lack of buyers in the market. You don't have to worry about CDOs. Just know that from a standpoint of how the markets actually function, the proportion of buyers and sellers needs to be consistent for there to be a liquid market.