How important is liquidity risk for sovereign bond risk premia? Evidence from the London stock exchange

Using a unique data set this paper studies the relationship between market liquidity risk and sovereign bond risk premia The London Stock Exchange during the late 19th century is an ideal laboratory in which to examine the effect of market liquidity on sovereign bond prices This period was the last time when the debt of a heterogeneous set of countries was traded in a centralized location and for which sufficiently long time series of observable bond prices are available to conduct asset-pricing tests Empirical analysis of these data establishes two results First liquid sovereign bonds carry larger factor loadings on market liquidity than liquid bonds The difference in average excess returns is not only due to the larger transaction costs associated with holding illiquid bonds but also to the greater sensitivity of the returns of illiquid bonds to fluctuations in market liquidity Second excess bond returns are linearly related to the returns of a liquidity-mimicking portfolio in the cross section indicating that market liquidity is a priced common risk factor At about 2 8% per year the price for bearing liquidity risk is economically significant Overall this evidence underscores the importance of understanding the effect of market liquidity on bond prices even in an economic environment that seems remote from today s Crown Copyright (C) 2010 Published by Elsevier B V All rights reserved