Is liquidity priced in the corporate bond market? A new approach

This paper presents a new approach to study relative liquidity effects in defaultable bonds. The new methodology developed here abstracts from specific structural models of credit risk by focusing on relative pricing effects and enhancing the robustness of the results obtained. We study relative liquidity and tax effects in the U.S. market for corporate and agency bonds over the period 1986--98. We show that bonds that trade infrequently are priced at a discount and have typically a smaller amount outstanding, suggesting that issue size is related to bond liquidity. We find evidence of a small liquidity effect of the order of 5 basis points related to issue size and that the liquidity of a bond decreases with the age. Recently issued corporate bonds trade at a premium over seasoned debt instruments, as it occurs in the Treasury market for on-the-run and off-the-run long-term bonds. Liquidity effects are consistently of the same magnitude across corporate bonds. We find supporting evidence that liquidity premia in corporate bonds covary with other factors related to investors' liquidity preferences. This suggests that the pricing of liquidity across different securities may be driven by common factors. We conclude that liquidity and tax effects are too small to explain the variation of yield spreads across credit rating and business sectors. However, differences in issue size can explain an economically significant 10 basis points of the corporate-Treasury rate spread.