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The conventional reason I see for this everywhere is that "investors take on larger risk locking up their money for longer."

This is unsatisfactory for me because of the secondary market. The price of a 30-year bond, for example, should be increasing by YTM% (yield-to-maturity) since the NPV of all future outflows increases (less time till the outflows).

So comparing a 30-year bond and a 1 month bill, why can't an investor buy the 30-year bond, hold it for a month, then sell it?

Both bond and bill are exposed to interest rate risk the same time. Furthermore, the sum of the bond's outflows + higher price, as mentioned above, should produce YTM% of value. So now since the 30-year bond's yield is higher than the 1 month bill, the investor should make more with the 30-year bond.

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Existence of secondary market only reduces liquidity risk. It does not affect the inherent risk of purchasing long term debt because situation can change. For example, long term bonds have higher interest rate risk because there is higher chance that interest rate will change in long term than in the short term (and raise in the interest rate will lead to lower bond price).

People at a secondary market will not buy bonds from you at any price you will fancy. Any prospective buyer will take into account that long term debt is more risky even if there is a secondary market. Advantage of secondary market is that it makes the bonds more liquid so it primarily reduces liquidity risk but virtually all other sources of risk remain unaffected, and generally (from a perspective of a buyer) the risk of buying debt increases with the time to maturity of the debt and so the buyer has to be compensated for that (plus there is the time value of money - money now is always better than money tomorrow). For example, the person that buys the bond from you will have to either factor in the price that either they will have to hold the bond to maturity (with all risks that carriers) or find another buyer who will then have to factor in the same problem. The bond will have to end up in someone's hands at the end of the day so all disadvantages of holding that long term debt will be priced at secondary market as if the bond would be held to maturity from the date the transaction is made (save for liquidity related issues).

Consequently, in the end regardless of whether secondary market exists it generally does not change riskiness of purchasing bond save for the liquidity risk. Since longer term debt is riskier for buyer (e.g. interest rate risk etc.) they need to be compensated more for purchasing it than in the case of short term debt that carries less risk.

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  • $\begingroup$ I agree that the secondary market only takes away liquidity risk, but I'm trying to differentiate between a world where you buy the 30-year bond and cannot sell it vs. our world. Of course the latter is more valuable. "long term bonds have higher interest rate risk" is what I'm trying to dig into. I posed a hypothetical in my question to make it more clear. $\endgroup$ Dec 27 '20 at 8:00
  • $\begingroup$ @curiousgeorge but the above already answers that. Okay let me give you concrete oversimplified example. Suppose that every person needs 1e compensation for every 1 time period of waiting. That means that 10y bond would need to in itself include 10e compensation 5y bond 5e etc. Now you claim that because bond can be sold on secondary market it should always be equal to 1 period compensation but that does not make sense. On secondary market anyone who will ends up with the bond will require that compensation. For example, if you buy the bond with 10e 10y compensation and immediately sell it $\endgroup$
    – 1muflon1
    Dec 27 '20 at 12:52
  • $\begingroup$ every buyer will require that you pass that 10e compensation on them. If you wait 1 time period (t=2) the bond now only has 9 years to maturity so if you sell it now everyone will require 9e compensation for the remaining period and you will earn your 1e 1 period compensation - but you have to ask in the 1st period for all 10 period compensation otherwise you would loose money - and so on the chain could go up to the last period. Hence, the secondary market does not change the calculation (aside from liquidity concern) of what is the bond worth vis-a-vis situation where you would keep till end $\endgroup$
    – 1muflon1
    Dec 27 '20 at 12:55
  • $\begingroup$ I see what you're saying but the following is not clear. Lets say the price of a 1 year bond is P - 1e and the price of a 10 year bond is P - 10e. Then it's not clear that the yield of the 10 year bond is higher because the term is longer. The answer then is maybe the 10th unit of variance costs more than the 1st unit of variance? So the risk premium is more than 10e? $\endgroup$ Dec 27 '20 at 22:06
  • $\begingroup$ @curiousgeorge risk premium is just 1 example - this would work assuming there is some constant risk as simplification, if the risk is not constant then price would also depend on how it changes. However, just change risk premium for time value of money - even with 0 risk you need to be compensated for holding the asset (this is by the way not the same as a liquidity) and again everything above would apply $\endgroup$
    – 1muflon1
    Dec 27 '20 at 22:08

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