What is the liquidity risk in fixed income? (2024)

What is the liquidity risk in fixed income?

Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. When a bond is said to be liquid, there's generally an active market of investors buying and selling that type of bond.

Fixed income market liquidity plays a crucial role in the conduct of monetary policy and the stability of the financial system. Therefore, central banks have a vital interest in monitoring liquidity conditions as well as the drivers that affect their robustness during episodes of market stress.

Summary. Fixed income risks occur due to the unpredictability of the market. Risks can impact the market value and cash flows from the security. The major risks include interest rate, reinvestment, call/prepayment, credit, inflation, liquidity, exchange rate, volatility, political, event, and sector risks.

From an investment perspective, liquidity risk relates directly to how easy it is to buy or sell assets. The more liquid an asset is, the easier it is to convert it to cash and find ready buyers. Assets that are illiquid take more time to convert to cash and sell.

The definition of liquidity we end up solving for is “the ability to exit a position at or near the current value.” Given this definition, a possible approach for estimating liquidity at the security level involves quantifying a security's future potential trading volume capacity (which is associated with “ability to ...

Liquidity can arise from either the inherent nature of the asset or the market conditions. For example, fixed deposits are accessible investments that can be withdrawn whenever you need them. You can withdraw money in an emergency even before the maturity tenure, by paying a premature withdrawal charge.

As commonly defined, “liquidity” measures how much trading volume a financial market can absorb for a given change in price or what the price impact of a given trade volume will be.

Default Risk: It is the possibility that the bond issuer might fail to repay the fixed interest and the principal amount. This risk can be measured by checking a company's credit rating, and investors must check it before investing.

One of the biggest benefits of fixed-income investing is that it's considered low-risk. That's not to say there is zero risk associated with investing in fixed-income assets, but these investments are typically less volatile and provide a predictable rate of return.

Equity markets offer higher expected returns than fixed-income markets, but they also carry higher risk. Equity market investors are typically more interested in capital appreciation and pursue more aggressive strategies than fixed-income market investors.

What is the liquidity risk?

Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.

The three main types are central bank liquidity, market liquidity and funding liquidity.

To measure the liquidity risk in banking, you can use the ratio of loans to deposits. A liquidity risk example in banks is a decline in deposits or rise in withdrawals (which are liabilities for the bank). As a result, the bank is unable to generate enough cash to meet these obligations.

While liquidity varies from bond to bond, the potential for decreased liquidity and investment losses exists for investors who sell their bonds before maturity at a time of market stress.

For example, when a company issues a bond and later becomes unable to repay that loan, it is deemed a funding liquidity risk. Such risks cause the value/price of a debt investment to decline significantly.

Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).

Bonds, such as U.S. Treasuries and corporate or municipal bonds, are traditional types of fixed income investments. Investors may also consider mutual funds and ETFs that hold fixed income investments.

Fixed-income investments are debt investments that pay a fixed interest rate on a set schedule. They enable investors to earn stable income until the investment matures. The income is the base return an investor makes from the investment. Upon maturity, an investor will receive their principal back.

A corporate bond's liquidity largely influences its ability to make large-scale, low-cost asset trades without causing large price changes. Researchers have found that strong links exist that tie systematic liquidity risk to the pricing of securities in the corporate bond market.

What is the relationship between bonds and liquidity?

In general, larger bonds are more liquid because they have more investors and lower inventory costs. Bonds become less liquid as they age because less active portfolios (belonging to so-called buy and hold investors) absorb progressively more of the issue.

For example, bond spreads increase during recessions. Moreover, the difference between spreads of long- and short-term bonds significantly widens during recessions, suggesting that investors shift funds into short-term bonds during this time, thus creating liquidity.

Bonds are the most common type of fixed-income security. Different bonds have different terms and credit ratings assigned to them based on the financial viability of the issuer. The U.S. Treasury guarantees government fixed-income securities, making these very low-risk but relatively low-return investments.

In conclusion: attractive yield and resilience

In current market circ*mstances, with higher bond yields, fixed income investments have become an attractive asset class again from a risk-return perspective.

Fixed-income securities typically provide lower returns than stocks and other types of investments, making it difficult to grow wealth over time. Additionally, fixed-income investments are subject to interest rate risk.