Liquidity Premium

What is Liquidity Premium?

The liquidity premium is the additional return that the investors expect for instruments that are not readily tradable and, therefore, cannot be easily converted to cash by selling at a fair price in the financial market.

The two terms – liquidity premium and illiquid premium – are interchangeably used as both of the terms mean the same, which means that any investor is entitled to receive an additional premium if they are locking-in into a long term investment.

Liquidity-Premium

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Source: Liquidity Premium (wallstreetmojo.com)

Liquidity Premium Theory on Bond Yield

The most common and closely examined investment pattern by the investors is the yield curve. These yield curves can be created and plotted for all the types of bonds, like municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more, corporate bonds, bonds (corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more) with different credit ratings like BB Corporate bonds or AAA corporate bonds.

This theory of Liquidity Premium shares the point that investors prefer short-term debt instruments as they can be quickly sold over a shorter period of time, and this would also mean lesser risks like default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more, price change risk, etc. to be borne by the investor. Below are some examples of the same.

Example #1

There are investments done in two government bonds – Bond A and Bond B. The below graph is depicting the effect of the maturity period or the duration an investment is held in terms of a number of years.

Liquidity-Premium graph
Time in YearsBond Yield for Instrument ABond Yield for Instrument B
51010
101111
151212
201515
302525

Instrument A is a Government bond with a longer maturity period than instrument A which is also a government bond investment. Instrument A has a maturity period of 20 years, while instrument B has a maturity period of 15 years only. In this case, Bond B is having a coupon rate or bond yield of approximately 12%, while the additional 3% is enjoyed by Bond A.

This additional benefit in terms of returns on your investment is termed as the Liquidity Premium. This premium, as clearly seen in the graphical representation above, can be provided if the bond is held for a longer maturity period as this premium gets paid to the investor only on the maturity of the bond held.

The above example is perfectly suited to explain the rising yield curve, which supports the liquidity premium theory. The same stands true in the case of the U.S. government, which is paying progressively higher rates to its investors for their investments in debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more with longer to much-longer maturities.

Example #2

Liquidity Premium might be a more prevalent concept for Government Bonds. At the same time, there are corporate bonds that provide the premium. in case an investor has planned to purchase two corporate bonds with the same time to maturity and the same coupon rates or coupon payments. However, in case only one of them is trading on a public exchange, and the other is not – this explains that the bond which is not trading on the exchange is exposed to different types of risks.

Since this is a non-public bond, therefore, the bond attracts a premium on maturity, which is termed as the liquidity premium. This premium is clear and defines the only reason and consequence of the difference in the prices of the bondsPrices Of The BondsThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more and yields for the same.

Advantages

  • It offers a premium to the investors in case of illiquid instruments – which means to attract certain investors and having them invested for a longer period of time and duration
  • Sense of satisfaction among the investors about the government-backed instruments about their will longevity, assurance, and constant and safe returns
  • Offers a direct correlation between risk and reward. In the case of illiquid debt instruments – there will the various risks involved that will be borne solely by the investor. Hence, providing the component of premium at the time of maturity is the reward one expects for the risk undertaken

Limitations

  • There can be cases where the liquidity premium can attract many investors to the illiquid market rather than the liquid instruments, which means a constant circulation of money/ money instruments in the economy
  • The reward provided for the risks undertaken might not be directly proportional to an investor.
  • A low premium at the time of maturity might affect the investor’s emotions in a negative way toward the government or the corporate house issuing it.
  • It is difficult for any issuing house or entity to define the premium and adjust to changing market and economic situations. Without a liquidity premium, also it gets almost impossible to attract new investors or maintain the existing ones.

Conclusion

Various debt instruments are subject to a variety of risks like event risk, liquidity risk, credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, exchange rate riskExchange Rate RiskExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies.read more, volatility risk, inflation riskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.read more, yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more risk, and so on. The higher the duration of the debt holding, the higher is the exposure to these risks, and therefore, an investor demands a premium to manage these risks.

However, it is up to investors to understand that liquidity premium could be only one of the factors for the slope of the yield curve. The other factors, for example, can be the investment goals of the investor, quality of the bond, etc. Also, for our point before we conclude as these the factors, the yield curve might not always be upward sloping – it might go zig-zag, flattening, or even inverted at times.

Therefore, as much as liquidity premium is essential for an investor, there are other theories that affect the yield curve and reflects the future expectation and the varying interest rates.

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This article has been a guide to what is Liquidity Premium and its definition. Here we discuss the theory of liquidity premium on yield curve along with the examples. You can learn more about accounting from the following articles –

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