Much Ado About Nothing: A Study of Differential Pricing and Liquidity of Short and Long Term Bonds

Research Retrieved: March 2019
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European pension funds and insurance companies manage a total of €17.5 trillion. For these institutions is crucial to have a precise estimate of the long-term discount rate used to discount their liabilities. Consequently modeling and understanding the long end of the nominal term structure has a direct policy relevance. This paper studies how pricing of short and long maturity bonds might differ, and it focuses on segmentation in yield and liquidity. The authors focus on the German sovereign bond market.

Key Findings

  • Although there are statistically significant differences in the pricing and drivers of short and long maturity bonds, the corresponding economic effect is rather small.
  • This means that observed long yields are not extensively distorted by demand pressure, default or liquidity premiums. It follows that there is little evidence of substantial yield segmentation in the German sovereign bond market.
  • Segmentation has different effect on the liquidity of short and long maturity bonds. The nature of liquidity varies along the yield curve. The liquidity of short maturities are more systematic, while liquidity on long-maturity bonds is independent from other market measures. Long maturity-bonds are in fact held by long-term buy and hold investors that do are less concerned about short-term fluctuations.

Relevance for Practice

The fact that bond yields are not distorted by institutional demand has important policy implications. There is extensive policy discussion on how to model discount rates for long-term liabilities of pension funds and insurance. The current approach is based on the ultimate forward rate method, which is an extrapolation technique used to calculate discount rates for maturities beyond the assumed last liquid point of the yield curve. The authors however suggests that, in light of their results, part of this methodology might be unnecessary. If long-term bond yields are not distorted, long-term discount rates could be extrapolated from the yields observed in the bond markets (up to 30 years). The rationale underlying the current regulation is to have reliable discount rate for very long maturities for which finding tradeable securities is difficult. However, the authors suggest that we can trust yields of long-term bonds, as any existing effect of segmentation on yields or liquidity are rather small.