bond illiquidity premium

[cgrady40]

if a lightly traded bond has an illiquidity premium built into its pricing, couldn’t buying and holding until maturity guarentee a source of alpha? (depending on the performance of the bond of its life)

 

[Galli]

Depends on what price you’re able to purchase the bond at.
A illiquid bond will have very few buyers and very few sellers which means it’s likely the Bid x Ask spread is very wide. Said differently, you’ll be buying at a premium price and selling at a discount to indice buyers/sellers to trade with you.

 

[S2000magician]

Galli wroteepends on what price you’re able to purchase the bond at.
A illiquid bond will have very few buyers and very few sellers which means it’s likely the Bid x Ask spread is very wide. Said differently, you’ll be buying at a premium price and selling at a discount to indice buyers/sellers to trade with you.

Holding the bond to maturity − the premise of the question − eliminates this shortcoming.

 

[Galli]

S2000magician wrote:

Galli wroteepends on what price you’re able to purchase the bond at.
A illiquid bond will have very few buyers and very few sellers which means it’s likely the Bid x Ask spread is very wide. Said differently, you’ll be buying at a premium price and selling at a discount to indice buyers/sellers to trade with you.

Holding the bond to maturity − the premise of the question − eliminates this shortcoming.

While it’s true holding to maturity elimnates selling the bond at a discount, the fundamental problem with assuming alpha generation from purchasing an illquid bond isn’t just holding to maturity to realize the implied alpha, it’s what price dealers are willing to sell to you that determines the alpha to begin with.
The crux of alpha generation in this situations assumes you can buy at a discount and hold to maturity. This isn’t typical which is evident by wide bid ask spreads.

 

[cgrady40]

Galli wrote:

S2000magician wrote:

Galli wroteepends on what price you’re able to purchase the bond at.
A illiquid bond will have very few buyers and very few sellers which means it’s likely the Bid x Ask spread is very wide. Said differently, you’ll be buying at a premium price and selling at a discount to indice buyers/sellers to trade with you.

Holding the bond to maturity − the premise of the question − eliminates this shortcoming.

While it’s true holding to maturity elimnates selling the bond at a discount, the fundamental problem with assuming alpha generation from purchasing an illquid bond isn’t just holding to maturity to realize the implied alpha, it’s what price dealers are willing to sell to you that determines the alpha to begin with.
The crux of alpha generation in this situations assumes you can buy at a discount and hold to maturity. This isn’t typical which is evident by wide bid ask spreads.

wouldn’t the premium have to be factored into the ask price though? no matter the spread? otherwise investors wouldn’t buy at a price that doesn’t compensate them fairly for the asset’s risks

 

[Galli]

Typically the spread itself makes the bond more risky as you pay a premium to buy and have to discount in order to sell.

 

[S2000magician]

The spread doesn’t add risk when you buy because there’s no uncertainty in the price. And the stipulation that you will hold the bond to maturity eliminates any selling risk.