Finance

What is Liquidity Premium Theory

Liquidity Premium Theory

Liquidity premium theory is a concept widely used in bonds. To put it simply, it signifies the existence of risk-reward in investment. Investors can earn higher returns by taking additional risks. You might have heard ‘the greater the risk, the greater the reward’. Investors take different types of risks and accordingly they stand chances to make incremental returns.

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Define Bonds. Suggest the investment horizon of bonds & their returns and risks:

Bonds are fixed-income instruments that pay the coupon on an annual/semi-annual/quarterly basis. Bonds have an investment horizon of 3 months to 10 years and more depending on the country. Longer-term bonds assume the economy shall continue to progress and offer higher rates of return because of higher risks involved over the long term. Investors shall invest in long term bonds but they will require adequate compensation to bear additional risks like interest rate risk( fluctuations in short & long term rates), credit risk( counterparty shall likely default on coupon/principal payments), liquidity risk(long term bonds have uncertainty due to unforeseen future hence cannot be sold at par to market prices). Investors can judge about investment prospects from yield curve (plotting returns & investment horizons).

Explain the liquidity premium theory:

The yield curve shows short term bonds require lesser risk because of fewer potential fluctuations in short term (for example- 3 months/ 6 months) and hence they tend to provide a lesser return. Investors demand a premium for exchanging convenience of liquidity over the investment of long-horizon (like 10 years). This explanation is consistent with the liquidity premium theory. Investors can make holistic judgments over the long term but they need to be compensated for unknown interest rate scenarios.  Hence, incremental higher returns are explained by higher liquidity premium for rewarding investors regarding unknown material interest rate risks.

In the above chart, it becomes clear that short term bonds don’t offer liquidity premium due to the ability to convert assets at nearly market price. Long term maturity bonds require investors to commit cash outlay for a significant time which shall mean investors have to be compensated for additional risk-liquidity premium for forgoing cash for relevant maturity periods.

We can observe the difference in liquidity premium between 5-year bonds & 30- year bonds. With incremental maturity, we see an upward curve of liquidity risk premium.

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Advantages:

  • Additional Risk premium helps companies attract patient capital (sustainable investment).
  • Investment of patient capital helps companies save significant costs of frequent rounds of raising financing through primary & secondary markets.
  • Investors with no immediate liquidity needs can invest in longer duration instruments & get better yields to cover the liabilities and exploit opportunistic investments due to potential surplus returns over a relevant time frame.

Disadvantages:

  • Liquidity risk premium assumes an upward sloping yield curve which may not be true in case of a recessionary or stagnant economy. The assumptions go for a toss in case of yield curve having inverse or flattened shape. Thus, the theory has its own limitations based on its assumptions.
  • Any kind of potential permanent change in the credit quality of an issuer exposes investments to the risk of downgrading of ratings which shall suffer returns significantly. Investors shall have their own set of reservations before committing large investments to their entities.

 

About the Author: Ashutosh Buch

About the Author:

Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program.  His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.

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