What happens when you have an asset that can’t be readily converted into cash? And what if you could actually earn money on that scarcely-traded asset?

We’re talking about the illiquidity premium, one option for long-term investors with fixed-income securities.

Of course, the illiquidity premium is a much-debated topic (some analysis even calls it a myth). Here’s what you need to know about the illiquidity premium—and whether it’s worth it.

Liquidity vs. Illiquidity

First, you have to understand the underlying concepts, which are familiar to investors: liquidity and illiquidity.

In investing, liquidity refers to the ease with which an asset can be converted into cash without degrading its market value. The most liquid of all assets is cash, but stocks are another excellent example of a highly liquid asset.

Conversely, illiquidity refers to an asset or security that cannot be easily converted into cash without significant degradation to its market value.

However, assets exist on a scale of liquidity. Lack of liquidity isn’t necessarily a bad thing—it just changes how you handle and plan for the asset.

What is the Liquidity Premium?

The liquidity premium is any form of additional compensation required to encourage investment in assets that cannot be easily converted to cash. In other words, you have an asset that can’t be liquidated easily, and the liquidity premium is tacked onto it to make it more appealing to otherwise hesitant investors.

If that sounds like a peculiar practice, it’s part of a broader risk calculation. Basically, because the asset in question isn’t liquid, there’s greater risk involved in purchasing it, since the investor can’t realize returns easily. Illiquidity as a whole is viewed as an investment risk, since the investor’s money is tied up.

The Yale Model

The Yale model provides an example of the liquidity premium in action.

In 1985, David Swenson was hired as Chief Investment Officer of Yale University. At the time, the university endowment was $1 billion. As of 2019, the endowment is valued at $29 billion, a direct result of how Swenson managed the endowment.

Basically, Swenson rewrote the rules of how to manage an endowment. The gist was simple: Swenson shifted the endowment’s focus away from liquid assets (like domestic equity and fixed income) toward illiquid assets (like private equity, hedge funds, and real estate). In doing so, he took advantage of the illiquidity premium by locking up the money for extended periods in diversified assets.

And while a university endowment isn’t exactly comparable to an individual investor’s portfolio, it delivers the essential lesson of liquidity premium theory: that there’s value in locking up your money for extended periods of time.

The catch, of course, is that investors tend to be leery of locking up their money for extended periods. IN fact, according to liquidity premium theory, investors tend to prefer highly liquid, short-term assets over illiquid, long-term assets, even though they can realize gains with those illiquid assets. Liquidity premium theory argues that you can incentivize investors to take advantage of long-term gains if you give them reassurance to counterbalance their risk.

So…What is the Illiquidity Premium?

That’s the liquidity premium—so what’s the illiquidity premium?

Let’s say you have two bonds. We’ll call them A bonds and B bonds. They’re traded on different exchanges, but otherwise, they’re completely identical. They have a 2% risk-free rate of return and investors hold them for one year on average. The central bank is the market-maker, supplying cash on demand for bonds. To cover costs, the bank’s price is a bit below the fair market value of the bond. The subsequent bid-ask spread is the cost of trading. For A bonds, that’s 1%, but for B bonds, whose market is less efficient, it’s 4%.

That’s important because the bond yield varies based on trading costs. Since investors make one round-trip sale-and-purchase each year, the yield on A bonds is 3% (the 2% risk-free rate plus a 1% trading compensation fee). But for B bonds, the yield is 6%.

That 3% additional yield is the illiquidity premium.

How It Works

The whole idea of the illiquidity premium is to benefit from the fact that the asset isn’t traded heavily. The illiquidity premium happens because when markets are illiquid, the purchase or sale of an asset can move prices substantially, even if the purchase or sale happens in small quantities.

This quirk of the market means that selling quickly is actually a risk for investors—after all, if they try to sell quickly, they may face higher costs. In order to make the sale attractive, the yield has to be higher. The thing is, illiquidity doesn’t matter as much when you have longer investment horizons. Remember, illiquid assets don’t convert to cash easily. But the longer you have to recoup the cost of purchase and add value to the asset, the less illiquidity matters.

The catch, of course, is that you have to be patient enough to outlast the market. You also have to be willing to tolerate the risks, since your money is tied up for a longer period of time and the risks may be bigger than you thought at first.

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