Modelling the liquidity premium on corporate bonds

Paul van Loon, Andrew Cairns, Alexander McNeil, Alex Veys

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Abstract

The liquidity premium on corporate bonds has been high on the agenda of Solvency regulators due to its potential relationship to an additional discount factor on long-dated insurance liabilities. We analyse components of the credit spread as a function of standard bond characteristics during 2003-2014 on a daily basis by regression analyses, after introducing a new liquidity proxy. We derive daily distributions of illiquidity contributions to the credit spread at the individual bond level and find that liquidity premia were close to zero just before the financial crisis. We observe the time-varying nature of liquidity premia as well as a widening in the daily distribution in the years after the credit crunch. We find evidence to support higher liquidity premia, on average, on bonds of lower credit quality. The evolution of model parameters is economically intuitive and brings additional insight into investors' behaviour. The frequent and bond-level estimation of liquidity premia, combined with few data restrictions makes the approach suitable for ALM modelling, especially when future work is directed towards arriving at forward looking estimates at both the aggregate and bond-specific level.
Original languageEnglish
Pages (from-to)264-289
JournalAnnals of Actuarial Science
Volume9
Early online date16 Feb 2015
DOIs
Publication statusPublished - Sep 2015

Keywords

  • Liquidity premium
  • Corporate bonds
  • Credit spread
  • Bid-ask spread

ASJC Scopus subject areas

  • Economics, Econometrics and Finance(all)
  • Mathematics(all)

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