Explain how illiquidity shows up in credit markets and how a credit portfolio can limit the resulting risk

Corporate bonds trade over the counter through dealers, and most issues trade rarely after their first few weeks. Dealer inventories are small relative to the market, so liquidity can vanish in stress just when investors want to sell, and bid-ask spreads widen most for lower-rated, smaller and older issues. Managers respond by holding a buffer of cash and government bonds, favouring larger and more recently issued bonds, using liquid instruments such as CDS indexes, ETFs and total return swaps, and stress-testing how long positions would take to sell. Investors with long horizons and stable funding may deliberately earn the premium that illiquid issues pay. The trap is measuring liquidity in calm markets, since transaction costs can multiply in a sell-off.