Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations
74 Pages Posted: 2 Jun 2020 Last revised: 24 Feb 2021
Date Written: April 1, 2020
I employ corporate bond liquidity premium to understand the important changes in corporate bond market liquidity in the recent periods. I show that while the commonly-used transaction cost measures such as the bid-ask spread have been declining, corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread is now compensation for illiquidity. To demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, I develop an estimation of the latent trading delays implied by the size of the liquidity premium, and show that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium. I show that Basel II.5 contributed the most to the increasing liquidity premium out of all regulatory changes over the sample period. The evidence is consistent with practitioners' description of the post-crisis market situation and corroborates the relevance of using liquidity premium in understanding corporate bond market liquidity.
Keywords: Corporate Bond, Liquidity Premium, Trading Delays, Basel II.5
JEL Classification: G10, G12, G18, G20
Suggested Citation: Suggested Citation