Investor Corner/The asset classes/Debt Concepts
2.2.9 Liquidity Risk
Liquidity risk is the risk that you cannot sell an investment quickly without accepting a meaningful price concession. It matters most for less-traded bonds and thinly traded smaller companies.
The gap between value and sellable price
An asset can have a perfectly reasonable fair value while still being hard to sell quickly at that value, if there are few buyers actively interested at any given moment. Trying to sell in a hurry under those conditions often means accepting a lower price than the asset would otherwise be worth, simply to find a willing buyer fast enough.
A liquid asset can be sold quickly at or near its fair market value. An illiquid asset either takes a long time to sell or can only be sold at a significant discount to its estimated value. Liquidity risk in debt markets is the danger that when you need to sell a bond, there are too few buyers, and the price you get is substantially below what the bond is theoretically worth based on its credit quality and yield.
Where it shows up in debt markets
Government securities and large, frequently traded corporate bonds are generally easy to buy and sell at a fair price on short notice. Smaller corporate bond issues, and bonds from less well-known companies, can trade rarely, sometimes days or weeks apart, which means a seller in a hurry may have to accept a real discount to find a buyer at all.
The Indian corporate bond market is far less liquid than the equity market or even the government bond market. Trading volumes are concentrated in a handful of AAA-rated issuers and PSU bonds. Lower-rated corporate bonds can go days or weeks without a single trade. When a mutual fund needs to sell such bonds (for example, to meet redemption requests), it may have to accept a price well below the fair value at which the bonds were marked in the NAV. This creates a real risk of loss for remaining investors in the fund, whose NAV is now based on overvalued, illiquid holdings.
The IL&FS crisis of 2018 exposed this risk starkly. Several debt funds held IL&FS group paper that became effectively unsaleable overnight after the default. The bonds were still marked in the NAV at their pre-default values for a period, creating a misleading picture of fund value. When the write-downs finally hit, NAVs dropped sharply. SEBI subsequently mandated stricter side-pocketing rules to segregate defaulted securities and protect remaining investors.
Why it matters for fund investors
A debt fund holding illiquid bonds can run into serious trouble if many investors ask to redeem at the same time, since the fund manager may be forced to sell those bonds quickly, at unfavourable prices, to meet redemptions. This is precisely the scenario that fund-level liquidity management, and mechanisms like side-pocketing, exist to address.
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For retail investors, the practical takeaway is to prefer debt funds that hold highly liquid instruments: government securities, AAA-rated PSU and corporate bonds, and short-term money market instruments. These can be sold without significant price impact even during stressed market conditions. Funds that chase higher yields by holding illiquid lower-rated paper may look attractive in calm markets but can trap investors during a crisis when redemptions are most urgent.