How is the liquidity premium measured in corporate bonds?

Question

AcadiFi · Accepted Answer

The total corporate bond spread decomposes conceptually into:

Spread = Expected credit loss + Credit risk premium + Liquidity premium + Tax and other

Liquidity premium compensates investors for inability to trade at fair value without market impact. Measurement approaches:

1. **On-the-run vs off-the-run**: Compare yields on recently issued (liquid) vs seasoned bonds of same issuer and similar maturity. The yield gap is largely liquidity.
2. **Bid-ask spread based**: Liquidity premium ≈ half-spread × annual expected turnover adjusted for holding horizon.
3. **CDS basis**: Cash bond yield over Treasury minus CDS spread approximates liquidity + other non-credit factors.
4. **Trade volume / TRACE data**: Higher trade frequency correlates with lower liquidity premium.

Example: Solstice Energy issues a benchmark 10-year at Treasury + 185 bps. CDS on same credit trades at 135 bps. Cash-CDS basis = 50 bps, largely reflecting liquidity and tax. A recent new-issue premium analysis showed 22 bps concession at pricing for illiquid tranches. Conclusion: liquidity premium ~25-50 bps depending on method.

During stress (e.g., March 2020, March 2023), liquidity premiums widened dramatically — 40 bps under normal conditions to 140 bps in crisis. Investors earning the liquidity premium must have holding horizon long enough to avoid forced sales during dislocations.

Liquidity premia explain why similar-credit-quality investment-grade bonds with smaller issue sizes (<$500M) trade consistently wider than benchmark-sized issues.

How is the liquidity premium measured in corporate bonds?

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