Question

Why do bondholders prefer short-term maturities to the long-term ones? What explanation does Liquidity Premium Theory offer?

Answer 1

Term to maturity is the remaining life of a bond. The duration ranges between the time when the bond is issued until it's maturity date when the issuer is required to redeem the bond and pay the face value of the bond to the bondholder.

The time of maturity can be either short term or long-term and each duration comes with varying Interest rates. Bonds with a longer term to maturity offer a higher interest rate than short term.

A short term bond is a bond with a term to maturity of between 1 to 5yrs. It can be issued by any entity such as investment- grade , corporations, government institutions and companies rated below investment grade and they are preferred by bondholders who are looking to preserve their capital since they tend to hold up better when market conditions are unfavorable.

Short term bonds are highly liquid, investors can access their capital with ease compared to a long term bond that tens to lock investors in for a long period.

Short term bonds come with low risk and low yields. They are preferred by investors whose top priority is the safei of their investments.

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Liquidity refers to how quickly an asset can be sold without lowering it's 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.

It also contends that investors are compensated for higher default risk and price risk from changes in Interest rates

It definitely indicates that the security which the investors have invested into is easily able to be converted into cash for its fair market value meaning that the security is very much liquid and the investor demand a reduced compensation on the security.