Bond Liquidity Premiums: Evidence from Catastrophe Bonds with Exogenous Default Risk

Abstract

Based on a TRACE dataset of 9393 cat bond trades on the secondary OTC market from 2015 to 2019, we analyze trading patterns, liquidity determinants, and the liquidity premium of catastrophe bonds. We find that cat bonds are mostly traded without inventory involvement of dealers, and they are less frequently traded during the hurricane season. Based on 3341 dealer-buy and dealer-sell trade pairs from 229 cat bonds with exogenous default risk, we find that liquidity is high for bonds with low default risk, bonds close to maturity, and in periods of high trading activity in the overall market. Using bid-ask spreads as a liquidity measure, we find that 21% of the observable yield spread on the cat bond market is attributable to the liquidity premium, with an average liquidity premium of 98 bps, which even increases to 141 bps for high-risk bonds.

Keywords: bonds, liquidity, yield spreads, alternative risk transfer

JEL Classification: G12, G22, G32