Research

Why is it cheaper to trade debt with a shorter maturity?

For many different debt instruments and markets, it is cheaper to trade short maturity debt and more expensive to trade long maturity debt. For instance, Figure 1 shows how the bid-ask spread for Italian treasury bills ("Buoni Ordinari del Tesoro") is lower for bills with a lower remaining time to maturity. The equivalent pictures for many other types of debt look very similar. To establish this more formally, one would want to control for other factors that affect transaction costs, such as e.g. credit quality or age. Edwards et al. (2007) or Bao et al. (2011) do this for US corporate bonds, and find that their preferred measure of transaction costs (estimated transaction price spread or negative price autocovariance, respectively) increases in time-to-maturity.

Figure 1

Bid−ask spread of Italian treasury bills (BOT)

Legend: Bid-ask spread (in basis points of face value) against remaining time to maturity (in days) for Italian treasury bills ("Buoni Ordinari del Tesoro"). The dashed line is the fitted bid-ask spread from a simple regression. The size of the coefficient in the regression implies that an extra 10 days of maturity imply an extra 4.4 basis points of bid-ask spread. Data: Borsa Italiana, retrieved on September 5, 2016.

Why would it be cheaper to trade debt with a shorter remaining time to maturity? One explanation goes as follows: For an investor who is considering selling a bond, the closer the bond is to maturity, the more attractive is the option to refrain from trade and simply wait for repayment at maturity. Market makers in over-the-counter markets or liquidity providers in electronic limit order book markets both know this, and hence need to set higher bid prices the closer the bond is to maturity.

This has implications for the issuers: Since investors want to be compensated for the transaction costs, issuers can borrow at a lower cost when issuing debt with shorter maturities.

This mechanism has been described by e.g. He and Milbradt (2015), Chen et al. (2013), and Chen et al. (2015). They also point out that as a firm comes closer to bankruptcy, investors fear being locked into a lengthy bankruptcy process. As the firm becomes more likely to become bankrupt, waiting for repayment therefore becomes a worse and worse outside option. Hence market makers can get away with setting very low bid prices for these bonds, and the bid-ask spreads widen. But the higher bid-ask spreads will make it more expensive for the firm to re-issue any maturing bonds, as investors now demand higher yields in the primary market, pushing the firm further towards bankruptcy. So there is a feedback loop between credit quality and bond liquidity. When choosing maturity initially, a firm will consider that a shorter maturity implies lower transaction costs for investors, but also that it makes it more likely that re-issuance is necessary if the firm gets into trouble.

There is another implication of this mechanism. In very liquid markets where many potential buyers compete and hence bid-ask spreads are already tight, maturity might not matter so much, but in less liquid markets, it may well matter. But how liquid the market is will also depend on the maturities available in the market. If sellers get to sell at higher bid prices, this also means that market makers also have to pay these higher bid prices. This means that secondary markets with (on average) very short maturities are not attractive for market makers, so few of them are likely to be present. Since there are few market makers, there is not much competitive pressure on bid-ask spreads.

A case in point would be the US commercial paper market. The typical investors in such paper, money market funds, need to be able to quickly and cheaply liquidate their positions to meet possible outflows. Because the secondary market is very illiquid, the maturity matters a lot to them, and issuers choose very short maturities. But precisely because the maturities are so short, the secondary market is not attractive to market makers, meaning that there are very few of them and the market is illiquid in this sense. Put differently, short maturities crowd out market makers.

In a recent paper (Bruche and Segura 2016), we model this feedback loop between secondary market liquidity and maturity choice. A key conclusion is that issuers do not fully internalise the effect that their individual maturity choice has on the liquidity of the secondary market. Collectively, issuers therefore choose maturities that are too short. As a consequence, secondary markets are too illiquid. This argument suggests that the push by regulators to get banks to reduce their reliance on short-maturity funding (e.g. via the Net Stable Funding Ratios of Basel III) may also have the effect of making market making more profitable and crowding in market makers, and in this sense improve liquidity of the secondary market.

References

Bao, J., Pan, J., Wang, J., 2011. The illiquidity of corporate bonds. Journal of Finance 66, 991-946.

Bruche, M. Segura, A. Debt maturity and the liquidity of secondary debt markets. Working paper, available at SSRN.

Chen, H., Cui, R., He, Z., Milbradt, K., 2015. Quantifying liquidity and default risks of corporate bonds over the business cycle. Working paper, available at SSRN.

Chen, H., Xu, Y., Yang, J., 2013. Systematic risk, debt maturity, and the term structure of credit spreads. Working paper, available at SSRN.

Edwards, A. K., Harris, L. E., Piwowar, M. S., 2007. Corporate bond market transaction costs and transparency. Journal of Finance 62, 1421-1451.

He, Z., Milbradt, K., 2014. Endogenous liquidity and defaultable debt. Econometrica 82, 1443-1508.

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