As a new investor, you might come across a concept known as liquidity risk—the hazard that an investment you are interested in may lack a ready market of either buyers or sellers. Liquidity refers to an asset that has a ready and waiting market on both sides of the buy-sell equation. It is important you understand what liquidity risk is and why it is important because it could pose a significant threat to your financial well-being unless you protect against it. Liquidity risk can attack you in other, unexpected ways.
Liquidity Risk: The Short Version
In the simplest terms, liquidity risk refers to the risk that an investment won't have an active buyer or seller when you are ready to make a transaction. If you are selling, this means you will be stuck holding the investment at a time when you need cash. In extreme cases, liquidity risk can cause you to take huge losses because you have to mark down your property at fire-sale prices to attract buyers.
To compensate for liquidity risks, investors often demand a higher rate of return on money invested in illiquid assets. That is, a small business can't be easily sold in most cases so investors are likely to demand a higher rate of return for investing in shares of it than they would a highly liquid blue-chip stock. Likewise, investors require a much smaller return for parking money in the bank.
One of the reasons for the losses suffered by financial firms during the Great Recession was the fact that these companies owned illiquid securities. When they found themselves without enough cash to pay the day-to-day bills and wanted to sell these assets, they discovered that the market had dried up completely. As a result, they had to sell at any price they could get—sometimes as low as a few pennies on the dollar.
The most famous case is Lehman Brothers, which was financed with too much short-term money. The management foolishly used this short-term money to buy long-term investments that weren't liquid—or rather, assets that became illiquid after the meltdown. When the short-term money was withdrawn, the firm couldn't come up with cash because they couldn't sell the long-term, illiquid securities fast enough to meet obligations. The stockholders were nearly wiped out despite the fact that Lehman was profitable and had a multi-billion dollar net worth.
On the upside, there is an opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets. Some of these "vulture" investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.
Risk of Widening Bid-Offer Spreads
Liquidity risk can appear as the bid-offer spread widens. When an emergency hits the market or an individual investment, you may see the bid and ask spread blow apart. As this gap widens the market maker may have a difficult time matching up buyers and sellers. That is, your shares of Company XYZ stock may have a current market price of $20 but the bid may have fallen to $14 on an expected bad earnings report. So, you can't actually get the $20 you want for your shares as the most someone is willing to pay is $14.
You often see very large spreads in thinly traded stocks and bonds. Whereas huge, liquid, blue-chip stocks will often have spreads as low as a penny or two.
Another type of liquidity risk is being cash-poor. This is the inability to meet cash obligations when a payment is due. It is the investment equivalent of defaulting on a debt.
If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date. Most of the time, businesses can refinance this debt through other bond offerings. But what happens if the debt markets aren't working. An example can be seen in the Great Recession when the credit crunch made it impossible to borrow money.
In that case, if the company couldn't come up with the whole $100 million, it could be hauled into bankruptcy court even if it is highly profitable. You would find yourself locked into what could be years of legal workouts due to the firm mismanaging its liquidity risk.
Inability to Raise Funds
A final example of liquidity risk can be seen if a company is unable to raise funding at a price they can afford. This situation can happen when it is impossible for a company or other investment to raise enough money to function properly and meet its needs at a price that is economical.
Wal-Mart Stores, Inc., for example, is one of the biggest and most profitable companies on the planet. It has tens of billions of dollars in debt in order to optimize the company's capitalization structure. Imagine the markets change suddenly. Now, instead of bond buyers being happy with 6% interest they may instead want 30% returns. Wal-Mart could no longer borrow at 6% and its cost of raising funds would increase drastically.
In effect, the market's liquidity would have dried up completely and the stockholders of Wal-Mart would have to worry about the company coming up with enough cash to wipe out all of its debt.
Protecting Yourself From Liquidity Risk
There are several ways you can help protect yourself from liquidity risk. First, never buy long-term investments that are illiquid unless you can afford to hold them through terrible recessions and job loss. If you might need cash in six months, don't buy a 5-year certificate of deposits (CDs) or an apartment building.
Remember that your total debt is less important than the amount of excess cash you have after making your debt payments each month. Fixed payments of $5,000 per month are overwhelming to someone with $6,000 per month income. The same payments are a rounding error to someone making $300,000 per month. All else being equal, the bigger the cushion between the cash you earn each month and the cash you must payout, the less the chance you get caught in a liquidity risk crisis.
Avoid investing in companies that are facing potential liquidity risks. Look at the company's debt refinancing plans. A review of the balance sheet should show long-term funding sources, such as shareholder equity instead of short-term deposits.