Liquidity risk is the risk of the market for a debt security drying up. The concept also applies to equity funds where it takes the form of impact cost, which is the adverse movement in a stock as a result of a mutual fund transacting in it. It is particularly an issue for large mutual funds in mid- and small-cap spaces.
Investors tend to redeem large sums of money from debt funds during economic distress, and this aggravates the existing liquidity problem, as happened in the case of Franklin Templeton in April. In its recent risk-o-meter circular, Sebi made liquidity risk a factor in assigning a risk classification to a debt mutual fund. The lowest weight (least risk) is for government and PSU bonds followed by AAA corporate bonds without credit enhancements, structured obligations or embedded options. The risk increases for lower-rated bonds and those with such exotic features.
