How Liquidity Premiums Are Calculated and Paid

A liquidity premium is the extra compensation required to get an investor to buy a security that is more difficult to sell quickly at a fair market price than an alternative. In other words, a security with a high liquidity risk – one that is difficult to sell relatively quickly at a fair price – must offer a buyer something extra than what a more liquid alternative offers. That “something extra” is known as the liquidity premium. Here’s what you need to know about this key investing metric.

A financial advisor can help you to use this premium as you consider additions to your portfolio.

Investment Liquidity, Defined

If you ever need to use a portion of your investment portfolio for an unexpected expense, you’ll find that certain assets are easier than others to convert to cash. This is called the investment’s liquidity.

An investment asset’s liquidity is its ability to be sold rather quickly and easily, at (or close to) fair market value. Some assets, such as savings accounts or short-term securities like Treasury bills, can be liquidated with ease. Investors simply need to withdraw the funds, cash out the certificates or sell the stock on the public market.

Others are a bit more troublesome to convert, however, and are considered illiquid investments. Certificates of deposit (CDs), for example, may result in penalties or even a loss if they are liquidated prior to maturity. An asset such as a home can take time and money to liquidate, even in a seller’s market. And securities that are not publicly traded may be very valuable in your investment portfolio but are often difficult or time-consuming to sell.

It’s wise to keep a portion of your investments liquid, in case you need access to those assets. However, illiquid investments also have an important role in your portfolio. That’s because illiquid securities can offer investors added compensation – the so-called “premium” – in exchange for assuming a greater liquidity risk.

Examples of Liquidity Premiums

An investment’s liquidity premium is built into the actual return of that investment. This often comes in the form of a higher interest rate or larger payout at maturity. Investors only need to look at their investment options to see how liquidity premiums play out in actual practice.

Liquidity premiums are the reason you’ll find five-year CDs offering much higher returns than six-month CDs. You’ll also notice that no-penalty CDs generally have lower returns than normal CDs of the same length, which charge an early withdrawal fee.

Government securities are another example. Treasury bills have a maturity date ranging anywhere from only a few days to one year in length. If you buy one you can be assured that your money won’t be tied up for long. As a result, they traditionally offer much lower returns than other government securities.

Treasury bonds, however, offer maturities of either 20 or 30 years, with much higher rates of return than Treasury bills. Even if you were to hold a Treasury bill for 20 years, its value still wouldn’t reach that of a 20-year Treasury bond.

How to Calculate Liquidity Premiums

To calculate liquidity premiums, you start by analyzing the yield on two comparable securities: one that is highly liquid and another that is less liquid but shares similar credit risk, maturity and other features. The formula involves subtracting the yield on the liquid asset from the yield on the illiquid asset. This difference reflects the liquidity premium.

For example, suppose a 10-year Treasury bond, which is highly liquid, has a yield of 3%, while a less liquid corporate bond with the same maturity and similar credit rating offers a yield of 3.5%. The liquidity premium in this case is 0.5% (3.5% – 3%). This premium compensates investors for the additional risk and inconvenience associated with holding a less liquid asset.

Factors such as market conditions, the size of the issue, and trading volumes can also influence liquidity premiums. By understanding these premiums, investors can better evaluate the true cost of illiquidity in their portfolios.

Bottom Line

When choosing how to build their portfolios, investors need to balance risk with potential returns. In most cases, the higher the risk you’re willing to take, the higher the potential reward. Depending on how and when you plan for those invested funds to be utilized, you may choose to invest in either liquid or illiquid assets. This difference is the investment’s liquidity premium, and it’s a key metric, especially for fixed-income investors.

Tips on Investing

Your investments must be a good match for your risk profile and timeline. That’s where a financial advisor can be an especially vital guide. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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