Trading in illiquid securities must be done with utmost care.
Need for diversification or high growth makes savvy investors dabble in illiquid securities. Some want to transact in tax free bonds, fixed maturity plans (FMP), closed-ended funds (CEF) or even non-convertible debentures (NCD) listed on stock exchanges. However, this is way different from buying a stock with fair volumes on the stock exchanges. Here are a few factors you should keep in mind:Choose the right security
This may sound really obvious. But it is a task in some cases. For instance, it is easy to buy shares of Shriram Transport Finance, but if you are keen to buy a listed NCD of Shriram Transport Finance then there are 13 options. The number of listed NCDs issued by Srei Infrastructure Finance stands at 34. Each of these options differ from each other in terms of rate of interest on offer, time to maturity, interest payout frequency, et al. If you want to achieve your desired outcome, you have to get the security right.Get the price and order right
“Never try to trade an illiquid security purely based on its last traded price. Instead arrive at a fair price at which the security should trade before placing your order,” Abhishake Mathur, Head-Investment Advisory Services at ICICI Securities, said. Bonds and FMP have accrued interest component in their price. While net asset value of FMP and CEF offer some clue about their fair price, bond prices must be ascertained taking into account yields quoted by similar bonds in the market on that day.
“Always place a limit order while trading a thinly traded security. It helps buy or sell desired security at a price one wants,” Mathur added. Most novice investors are used to placing a market order at the current price. A market order in case of illiquid security can create havoc. You may end up buying the security at much higher price than you anticipated or end up selling at a much lower price. The impact could be bigger if the quantity to trade is larger. Never ever let anyone take advantage of the illiquidity.
Getting the trade size right is essential for two reasons. First, how much of your portfolio is in investment opportunities. Allocate money as per your risk profile. Experts told Moneycontrol that each of these investment should not be over 2-5 percent of your portfolio.
Second, your bet size must be seen in light of the market environment. “If you are buying too small a quantity in government securities, it may be difficult to sell them in the market where most buyers are institutional and prefer lots above a certain minimum threshold,” Deepak Panjwani, Head – Debt Markets, GEPL Capital, said. If the security turns illiquid after you bought it, then you may find less number of buyers given the small quantity in your hand.Exit Strategy
“Before entering a trade, you should be clear about your exit strategy. Given there is low liquidity and higher spreads, there would be a cost attached while you sell. However that may not apply if you are prepared to hold it till maturity,” Mathur said. Just because a security is illiquid, does not mean you cannot negotiate hard with the seller while buying. The same holds good for you. Do not expect a fair price if you have to sell it in the market before maturity. “Only investors willing to hold on till maturity should buy illiquid bonds if they are available at attractive yields. Others must restrict themselves to liquid names,” Panjwani said.Transaction costs and taxes
This could be a hidden shock for a novice. Understand the taxation associated with payoffs offered by the security. Taxes pertaining to the capital gains must be accounted for before entering into a trade. Transactions costs such as brokerage must be taken into account. This is especially the case if you are buying into low priced FMP or CEF. If you get one or two units of the fund and the broker charges you minimum brokerage of Rs 20, then the transaction cost eliminates chance of a profit.To sum up, trading in illiquid securities must be done with utmost care. “If you are selling an illiquid security just because you are in need for short term funding, consider raising a loan. The price cut you have to take for selling such a security in the market sometimes exceed the interest you pay on a loan,” Joydeep Sen, Founder and CEO of wiseinvestor.in, said.