Understanding Illiquid Assets: Risks, Examples, and Market Impact

What Are Illiquid Assets?

Illiquid assets are securities or properties that you can't easily sell or exchange for cash without incurring significant losses. These assets often experience low trading activity and wider bid-ask spreads, increasing their volatility and risk. They include real estate, antiques, and private company stocks, which are generally harder to sell quickly. Understanding the challenges of illiquidity can help you make informed decisions and avoid potential financial pitfalls.

Understanding Illiquidity and Its Market Implications 

Regarding illiquid assets, the lack of ready buyers also leads to larger discrepancies between the asking price, set by the seller, and the bid price, submitted by the buyer. This difference leads to much larger bid-ask spreads than would be found in an orderly market with daily trading activity. The lack of depth of the market (DOM), or ready buyers, can cause holders of illiquid assets to experience losses, especially when the investor is looking to sell quickly.

Illiquidity in the context of a business refers to a company that does not have the cash flows necessary to make its required debt payments, although it does not mean the company is without assets. Capital assets, including real estate and production equipment, often have value but are not easily sold when cash is required. The sale of illiquid assets is not a company’s core business. They generally include any property owned by the company that is outside of the products produced for sale. In times of crisis, a company may need to liquidate these assets to avoid bankruptcy, and if this happens quickly, it can dispose of assets at prices far below an orderly fair market price, sometimes known as a fire sale.

Additionally, a company may become illiquid if it is unable to obtain the cash necessary to meet debt obligations.

Comparing Illiquid and Liquid Assets: Examples and Insights

Some examples of inherently illiquid assets include houses and other real estate, cars, antiques, private company interests and some types of debt instruments. Certain collectibles and art pieces are often illiquid assets as well.

Stocks that trade on over-the-counter (OTC) markets are also often less liquid than those listed on robust exchanges. Though these assets may have inherent value, the marketplace in which they are sold often has few buyers in comparison to those interested in the purchase of more liquid assets.

On the other end of the spectrum, most listed securities traded at major exchanges, such as stocks, ETFs, mutual funds, bonds, and listed commodities, are very liquid and can be sold almost instantaneously during regular market hours at fair market price. Additionally, precious metals, such as gold and silver, are often fairly liquid. Trading after normal business hours can also result in illiquidity because many market participants are not active in the market at those times.

An asset's liquidity may change over time, depending on outside market influences. This change in price is especially true for collectibles, as an item's popularity in the consumer market may fluctuate dramatically, leading to highly volatile pricing.

The Risks Associated With Illiquid Assets 

Illiquid securities carry higher risks than liquid ones, known as liquidity risk, which becomes especially true during times of market turmoil when the ratio of buyers to sellers is thrown out of balance. During these times, holders of illiquid securities may find themselves unable to unload them at all, or unable to do so without losing money.

Illiquid securities might have a liquidity premium to account for their difficult sale later on. During times of financial panic, markets and credit facilities may seize up, causing a liquidity crisis, when sellers of even marketable securities find it challenging to find eager buyers at fair prices.

Real-World Illiquidity: The Case of Jet Airways

Illiquidity can leave both companies and individuals unable to generate enough cash to pay their debts. For example, The Economic Times reported that Jet Airways had delayed repayment of overseas debt for the fourth time “in recent months” due to a corporate illiquidity crisis that left the company struggling to access liquid funds. As a result, Jet Airways not only had to ground more than 80 planes, but it also put together a resolution plan that called for the resignation of its chair, Naresh Goyal, and the board voting to allow lenders to take control of the airline.

The Bottom Line

Illiquid assets present significant challenges due to their inability to be quickly converted into cash without significant loss in value. This illiquidity can lead to wider bid-ask spreads, greater price volatility, and increased risk for investors. Understanding the characteristics of illiquid assets, such as real estate and collectibles, is crucial for investors, particularly during market turmoil. Companies may face financial struggles if they cannot liquidate assets to meet debt obligations, as highlighted by the Jet Airways example. Thus, it is essential for investors to balance their portfolios with liquid assets to mitigate potential liquidity risks.