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The Bond Liquidity Fallacy

 

The yield curve is a most amazing construct. It beautifully illustrates where risk is priced when it comes to credit. The longer you tie up your money, the higher the interest you can expect to receive, as clearly it is less risky to lend for a week than it is for 30 years. So far so good. But now people also want liquidity, e.g. the right to sell out of their debt obligation at any time, even though they bought an instrument that pays a yield based on the expectation that they hold a bond for 30 years, for instance. So how does that work and is there a free lunch?

 

The answer is no, there is no free lunch and pigs don’t fly. The only way you can 'lock in' a yield of a 30 year bond is to actually hold it until it matures. If you decided to sell out prior to expiry, you are subject to prevailing market interest rates and hence price risk. Say, for instance, you bought a 10 year Gilt and it yields 2%. Then, 2 years later you decide to sell the Gilt because you wanted to buy a house. If market interest rates have risen to 4% in the years since you bought the bond, then your 10 year Gilt could be worth as little as half of what you paid for it. Yes, you would get all the money back if you held the bond for another 8 years, but if you wanted to sell, the market price is what it is and it could mean huge losses.

 

Which kind of makes a mockery out of the whole idea of buying bonds as a low risk asset. But, as always, bonds are just a tool (investment instrument) and how we use them makes all the difference. When you buy bonds, you have to decide if it is for the yield, in which case buying a 10 year bond means that you actually hold it until maturity in 10 years time, or you buy bonds because you want to speculate on interest rates. They are entirely different matters. Just be aware that whether you use the liquidity or not, you are paying for it. Buying a government bond gives you daily liquidity, as you can sell it at any time in the market place. That is worth something, and buying a liquid instrument and not using it makes holding such an investment very expensive.

 

If you are willing to actually tie up your money for 10 years for instance, there are so many other potential investments giving much more attractive yields. Most 10 year private debt strategies yield more than 10% annually on average. To put that into perspective, if you bought a 10 year bond and say it yields 3% (to be generous), then thanks to the wonders of compounding you will have earned 34.39% in interest in ten years time. If however, you earned 10% per year on your investment, then in ten years you will have earned 259.37% in interest! A great part of that return can be explained as the compensation for illiquidity and it really makes you wonder why anyone is buying long dated public bonds in this environment.

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