The liquidity premium theory of interest rates is a key concept in bond investing. It follows one of the central tenets of investing: the greater the risk, the greater the reward. The theory is one of several that collectively seek to explain the shape of the yield curve – the interest rates that investors receive for buying bonds of different maturities.
The liquidity premium theory focuses on the question of how quickly an asset can be sold in the market without lowering its stated price.
Understanding the Yield Curve
One of the most closely watched graphs among investors is the yield curve, also known as the term structure of interest rates. It plots the yields, or investment returns, of a specific category of bonds on the y-axis against time on the x-axis. The most popular version of the yield curve tracks U.S. Treasury debt from three-month Treasury bills through 30-year Treasury bonds. Yield curves can be constructed for all bond types, such as municipal bonds or corporate bonds with different credit ratings, such as AAA-rated corporate bonds.
Evaluating the Liquidity Premium Theory
Liquidity refers to how quickly an asset can be sold without lowering its price. Generally speaking, markets with many participants are highly liquid relative to markets with fewer participants. The liquidity premium theory states that bond investors prefer highly liquid, short-dated securities that can be sold quickly over long-dated ones. The theory also contends that investors are compensated for higher default risk and price risk from changes in interest rates.
The following is an example of the liquidity premium theory in action from an Iowa State University online PowerPoint presentation:
- "Suppose one-year interest rate over the next five years are 5%, 6%, 7%, 8%, 9%, liquidity premiums for one to five-year bonds are 0%, 0.25%, 0.5%, 0.75%, 1.0%
- Then, interest rate on the two-year bond: (5% + 6%)/2 + 0.25% = 5.75%
- Interest rate on the five-year bond: (5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8%
- Interest rates on one to five-year bonds: 5%, 5.75%, 6.5%, 7.25% and 8%."
Upward-Sloping Yield Curve
An upward-sloping yield curve supports the liquidity premium theory. Suppose that the yield curve for U.S. Treasuries offers the following yields: 2.5 percent for three-month bills, 2.75 percent for one-year notes, 3.25 percent for five-year bonds, 4.5 percent for 10-year bonds and 6.25 percent for 30-year bonds. The rising yield curve is consistent with the liquidity premium theory, with the U.S. government paying investors progressively higher rates for debt with longer maturities.
Assessing Alternate Explanations
However, the yield curve isn’t always upward-sloping: sometimes it zigzags, flattens out or even becomes inverted. In these cases it’s clear that the liquidity premium theory alone is insufficient to explain the shape of the curve.
Economists have devised other theories to account for these situations, including the expectations theory, which states that the yield curve reflects future expectations about interest rates. Another approach is the market segmentation theory, which argues that financial institutions prefer to invest in bonds with maturities that match their liabilities.
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