What does liquidity risk in bond markets refer to?

Liquidity risk in bond markets specifically addresses the challenge that arises when a bond cannot be easily bought or sold in the market without significantly affecting its price. This type of risk is particularly pertinent for bonds that are not frequently traded or have a smaller market presence, as it may be difficult for investors to find a buyer or seller at their desired price.

If liquidity is low, the cost of trading can increase, meaning investors may have to accept a lower price when selling or pay a higher price when buying. High liquidity typically allows for quick transactions at stable prices, while low liquidity can create a gap between the buying and selling prices, thus making it riskier for investors.

In contrast, other options address different forms of risk. The risk of a bond being called early relates to callable bonds; interest rate risk pertains to fluctuations in interest rates affecting bond prices; and the risk of losing principal deals with credit risk or default risk rather than liquidity risk specifically. Understanding liquidity is crucial, as it can impact an investor's ability to enter and exit positions in the bond market effectively.