Investments the Consideration of Term to Maturity

¶ … Duration in the Investment Decision

Seasoned financial experts will consider numerous factors when considering potential investments. Common considerations for fixed term securities, such as bonds, will include risk and reward, with the reward assessed through the yield to maturity. However, while the element of yield is important, it should not be the only primary area of consideration; duration, or term to maturity, can also be an essential factor in an investment decision (Goldman Sachs, 2014; Gatzert and Kosub, 2014)).

The duration of an investment may be necessary for a number of reasons, these include, but are not limited, to the link between term and reward, market uncertainty, and the need for liquidity.

Duration and reward

Duration links to the risk and reward element of an investment decision. Generally, longer term investments will provide a higher return compared to short-term investments with similar perceived levels of risk. At the current time, there are poor rates of short to medium term bonds. For example German government 2-year bonds sold in 2014 had a yield rate of -0.38% (McClean and Lewin, 2015). This was a bond with a zero rate coupon, and is not an unusual bond in the marketplace (McClean and Lewin, 2015). In 2014, all German sovereign bonds with maturities less than three years had a negative yield (Goldman Sachs, 2014), and today 10 Eurozone countries also have two-year bonds with negative returns, and the overnight rate with the European Central bank was -0.2%, which is subsequently moved further into negative territory (McClean and Lewin, 2015).

This demonstrates the differential between short-term investment and long-term investment, and the way in which yields may be different. However, the current market conditions may be sooner than usual, but the differential between short- and long-term investment, with longer term investors providing for a higher than bottle short-term interest rate. This may indicate that there are many reasons for longer term durations to be preferred, especially as they are able to offer a greater yield to maturity. However, market uncertainty creates a difficulty determining whether any given yield rate will be advantageous in the context of future market changes.

Market uncertainty

In any marketplace there will be some uncertainty regarding future potential market/sector performance, and the returns that will be achieved. Fixed term investments may provide some advantages in term of minimizing the risk of uncertainty regarding the return of a particular investment. However, tying up capital in one investment, even if it appears to offer a high rate of return measured through the yield to investment, there is also a potentially great opportunity cost, which increases as the duration of a fixed term investment vehicle increases (Pindyck & Rubinfeld, 2009). Therefore, when considering duration, there may be some preferences for placing money in a relatively stable and safe environment in the short-term, while ensuring there is sufficient liquidity to take advantage of emerging opportunities when market conditions improve (Bodie, Kane, & Marcus, 2014). Therefore, if a financial investor seeks to maximise the potential opportunities for taking advantage of uncertainties in the marketplace, short duration investments may be beneficial, even if they appear to result in negative returns, is the opportunity cost may be less compared to tying up capital for longer periods of time and limiting growth potential. This leads to the important consideration of liquidity.

Liquidity requirements

Liquidity should be considered from both a practical perspective, as well as a regulatory/legal perspective. Investment, whether investment funds such as pooled investments or an investment portfolio for an individual or corporation, need to ensure there is sufficient liquidity to meet any potential short-term liabilities, such as wages and operating fees for the ongoing maintenance of the fund, as well as meet obligations. For example, life insurance companies with investments need to ensure sufficient liquidity to meet life claims, pension funds to meet the needs of those who will be retiring, not only with sufficient liquidity to meet needs, but also provide an acceptable level of unexpected contingencies (Bodie et al., 2014; Damodaran, 2006). Therefore, from a practical perspective it is essential that fund has sufficient liquidity. However, there is also regular to requirements regarding liquidity for different types of funds (SEC, 2015). Regulation is also under review, for example the SEC voted in September 2015 to implement a comprehensive package of reforms requiring for higher levels of perspective liquidity risk management in open-ended funds and mutual funds (SEC, 2015). Under the new proposals, any exchange traded funds would be required to undertake a liquidity risk management program, disclose the level of liquidity within the fund, and the associated redemption practices (SEC, 2015). The problem for many funds being a low level of liquidity may result in significant disadvantages to the fund, and therefore is invested, with fixed term investments need to be divested rapidly to improve liquidity (Bodie et al., 2014; Howells & Bain, 2007). The transparency would include indicating the number of convertible or liquid investments based on the number of business days required, including 2 to 3 days, 47 days, 8 to 15 days, 1635, more than 30 days (SEC, 2015). Within this environment, there is an even greater need for careful consideration, with the financial experts considering not only the practical needs of the fund, and reportorial requirements, but the views of the market and the way in which funds may be interpreted either as being too liquid, or insufficiently liquid.