Expected Bond Liquidity

Abstract

We introduce an approach to forecast individual bond liquidity and apply it to the U.S. corporate bond market. Our model combines three dynamic prediction models to get the most accurate estimate for future bond liquidity. We compare the new prediction methodology with the literature’s current approach to use a bond’s liquidity of today as the best estimate for its liquidity tomorrow. Our approach generates significantly lower forecasting errors and is much better able to capture the premium for expected liquidity in bond yields. We provide evidence that investors in corporate bond funds actively anticipate liquidity deterioration in underperforming funds and sell their shares in advance to secure a first-mover advantage.

Keywords: bond liquidity, bid-ask spread, forecasting, asset pricing, bond funds

JEL Classification: C10, C53, G12, G17, G20