A liquidity premium is the term for the additional yield of an investment that cannot be readily sold at its fair market value. The liquidity premium is responsible for the upward yield curve typically seen across interest rates for bond investments of different maturities. Generally, bonds of longer maturities have more market risk, and investors demand a liquidity premium.

Definition of liquidity premium

In a nutshell, a liquidity premium means that illiquid investments need to offer higher yields than liquid ones, all other things being equal. Usually this is used to help explain the difference between bond prices, particularly those of different maturities.

Here's a current example that illustrates this principal well. Bonds are a relatively illiquid form of investment, especially when compared with stocks. As of this writing, the yield on a 10-year U.S. Treasury bond is 2.39%. On a three-month Treasury, the yield is just 0.76%. While there is a low risk of default with U.S. government securities, there is certainly more risk that the U.S. government could default over the next 10 years than over the next three months. Therefore, the difference in yields is supportive of the liquidity premium theory.

Liquid investments vs illiquid investments

Liquidity refers to the ease with which an investment can be converted into cash, without making a significant sacrifice to market value.

Publicly traded stocks are an excellent example of a liquid investment. Stocks operate on a continuous-auction system, where the difference between the best price a buyer is willing to pay and the lowest price a seller is willing to accept is often just a cent or two. If you want to sell shares of a stock, you can enter an order to sell it at the highest price being offered (also known as the bid price), and the trade is generally executed in a few seconds.

On the other hand, real estate is a common example of a rather illiquid type of asset. To sell a house at its appraised market value might take weeks, months, or more. Sure, you can sell a house quickly if you're willing to accept significantly less than market value, but this is contrary to the idea of liquidity.

There are a wide range of degrees of liquidity, even among the same class of asset. Bonds are a good example -- for instance, short-term Treasuries can be very liquid. On the other hand, long-term bonds issued by a relatively small and unknown company can be rather difficult to find a buyer for on the open market.

Implications on the yield curve

It's important to mention that the liquidity premium is only one of several factors that collectively account for the yield curve. For example, another big factor is market segmentation theory, which says that buyers of bonds with different maturities have different characteristics and investment goals, and therefore the yields of bonds with one maturity cannot reliably be used to predict yields of another group of bonds.

The bottom line is that the liquidity premium helps to explain the difference between bond yields of different maturities, it's not the only factor that comes into play.

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