Liquidity Premium

What Is a Liquidity Premium?

A liquidity premium is any form of additional compensation that is required to encourage investment in assets that cannot be easily and efficiently converted into cash at fair market value.

For example, a long-term bond will carry a higher interest rate than a short-term bond because it is relatively illiquid. The higher return is the liquidity premium offered to the investor as compensation for the additional risk.

Understanding the Liquidity Premium

Investors in illiquid assets require compensation for the added risk of investing their money in assets that may not be able to be sold for an extended period, especially if their values can fluctuate with the markets in the interim.

Liquid investments are assets that can be easily and quickly converted into cash at their fair market value. A savings account or a short-term Treasury bond are examples. The returns may be low, but the money is safe and can be accessed at any time for its fair value. Many bonds are relatively liquid, as they are easily convertible or may be sold on an active secondary market.

Illiquid investments have the opposite characteristics. They cannot be easily sold at their fair market value.

Illiquidity is seen as a form of risk. The investor's money is tied up.

Liquid and Illiquid Investments

Illiquid investments can take many forms. These investments include certificates of deposit (CDs), certain loans, annuities, and other investment assets that the purchaser is required to hold for a specified period of time. The investments cannot be liquidated or withdrawn early without a penalty.

Other assets are deemed illiquid because they have no active secondary market that can be used to realize their fair market value.

The liquidity premium is built into the return on these types of investments to compensate for the risk the investor takes in locking up funds for a long period of time.

In general, investors who choose to invest in such illiquid investments need to be rewarded for the added risks that a lack of liquidity poses. Investors who have the capital to invest in longer-term investments can benefit from the liquidity premium earned from these investments.

The terms illiquidity premium and liquidity premium are used interchangeably. Both mean that an investor is getting an incentive for a longer-term investment.

Examples of Liquidity Premiums

The shape of the yield curve can further illustrate the liquidity premium demanded from investors for longer-term investments. In a balanced economic environment, longer-term investments require a higher rate of return than shorter-term investments — thus, the upward sloping shape of the yield curve.

As another example, assume an investor is looking to purchase one of two corporate bonds that have the same coupon payments and time to maturity. Considering one of these bonds is traded on a public exchange while the other is not, the investor is not willing to pay as much for the nonpublic bond. This means a higher premium at maturity. The difference in the relative prices and yields is the liquidity premium.