A liquidity premium compensates investors for investing in securities with low liquidity. Liquidity refers to how easily an investment can be sold for cash. T-bills and stocks are considered to be highly liquid since they can usually be sold at any time at the prevailing market price.
On the other hand, investments such as real estate or debt instruments are less liquid. It may take quite some time to sell real estate at the desired price. Some debt instruments must be held for a certain period of time before being sold.
Why do liquidity premiums exist?
Illiquid investments carry more risk than comparatively more liquid investments. This is because holding a single security for a long period of time exposes the investor to several risk factors, such as market volatility, potential default, economic downturns, interest rate fluctuations, risk-free rate fluctuations, etc. When investors tie up their money in a single security, they also incur the opportunity cost of investing in other assets that may outperform the illiquid investment. Due to the additional risks, an investor will demand a higher return, known as a liquidity premium.
Liquidity premiums and bond yields
Going by the idea that illiquid investments represent a greater risk for investors, the liquidity premium is one of the factors that explain differences in bond yields. A bond that matures in many years and that is issued by a little-known company without much financial data for investors to consult may be more difficult to sell. A bond with a shorter maturity issued by the same company would be a comparatively more liquid investment. Thus, investors who purchase that bond would require a lower liquidity premium. The concept is illustrated in the graph below:
Here, investors that buy Bond B command a higher return (a liquidity premium) to compensate them for investing in a less liquid investment. The example above assumes that all other factors are held constant (i.e., the only difference is time to maturity).
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