Liquidity and Redemption Risks
Liquidity risk
Investors typically hold a bond until it matures and get back the invested principal. However, some investors may wish to liquidate their investments before maturity, particularly in the case of longer-term bonds. Selling a bond prior to its maturity often proves difficult for amateur investors due to lack of understanding of bond prices and the possibility of the secondary market not being active. Even if they can sell it successfully, it can be only at the current market price. The investors will suffer a loss if the selling price is lower than the original purchasing price. Therefore, before investing in bonds, investors should prepare for potential failure to sell before maturity and also the risks associated with the liquidity condition.
Early redemption risk
In addition, some issuers may call back or redeem the bonds before maturity. This usually happens when interest rate goes down because that means the issuers can issue bonds at lower coupon to reduce interest costs. If a bond is redeemed early, the investor will not be able to obtain the expected return or will have to re-invest the proceeds and yields on other bonds in the market, usually at less favourable terms. Given this, callable bonds generally pay higher interest than non-callable bonds. Investors should pay attention to possible early redemption when buying a bond.
Nevertheless, these risks apply only to direct bond purchases. Investing in bond funds can spare investors from these worries since daily trading and redemption are allowed.