Practical Applications of (Il)liquidity Premium in Credit Markets: A Myth?

Practical Applications Summary

In (Il)liquidity Premium in Credit Markets: A Myth?, which appeared in the Winter 2019 edition of The Journal of Fixed Income, Scott Richardson and Diogo Palhares (both of AQR Capital Management) investigated the notion of the liquidity premium in corporate bond markets. They conducted several analyses based on multiple measures of liquidity, including the bid–ask spread, average daily trading volumes, issue size, price impact, and frequency of zero trading days. In almost every analysis, they found, illiquidity did not translate into positive risk-adjusted returns that were statistically significantly different from zero. The only relevant liquidity-related bond characteristic the authors discovered was time since issuance: older bonds were associated with higher future credit-excess returns. However, the authors did not interpret this finding as evidence for a liquidity premium, as more direct measures of liquidity had no relation to returns. Rather, the authors suggest that the higher positive returns on older bonds are due to the tendency of investors to avoid those bonds for some other, non-observable reason.

TOPICS: Fixed income and structured finance, analysis of individual factors/risk premia, fixed-income portfolio management