Why are longer term bonds less illiquid?

Discussion in 'SA2' started by curiousactuary, Aug 14, 2020.

  1. curiousactuary

    curiousactuary Active Member

    I read that bonds that are held until maturity are not exposed to illiquidity risk.

    1. I didn't understand why is this was so?

    I interpret this to mean that long term bonds are more liquid (less illiquid) than short term bonds? Is that correct or I have I misinterpreted this?

    I actually thought that long term bonds were less liquid than short term bonds but the above seems to suggest vice versa?
  2. mugono

    mugono Ton up Member

    In the first instance, it may be worth checking whether / how illiquidity risk has been defined, eg in the core reading.

    There likely is a term premium that usually increases (as the word suggests) with increasing maturity: however this isn’t explicitly split out, eg within Solvency 2 where the total spread is split into a fundamental spread (broadly downgrade + default) and a balancing item (broadly an illiquidity premium).

    A bond held to maturity will pay out in full provided that it does not ultimately default (lower rated assets are relatively more likely to default).

    Changes in the market’s view about a bonds default expectations (a credit rating provides a relative assessment of an issuer’s likelihood of default) is a risk that affects a buy and hold investor.

    A change in the market’s view about the illiquidity portion of the spread is argued to be a risk that a long term buy and hold investor such as an insurer is not exposed. This concept is important and provides a rationale for the existence of the Solvency 2 matching adjustment, which I would expect is captured somewhere in the core reading.
    curiousactuary likes this.
  3. Lindsay Smitherman

    Lindsay Smitherman ActEd Tutor Staff Member

    Just to add to the great response above:
    Illiquidity risk in this context basically means the risk of only being able to get a very depressed (low) price when you come to sell the bond. If you know that you are going to be holding the bond until maturity (because it is matching a predictable liability cashflow, for example) then you are never going to have to sell the bond - so you don't have illiquidity risk.
    curiousactuary likes this.
  4. James789

    James789 Active Member

    I think the first sentence from the OP is a bit clumsy which might add to the confusion.

    It would probably be better to say "an investor is not exposed to illiquidity risk on a bond he/she is certain to hold until maturity". After all, bonds, being financial instruments with limited sentience, are not really themselves exposed to any risk whatsoever.

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