Illiquidity and Its Threats - A Study of the U.S. Corporate Bond Market

Sammanfattning: In recent times of market turmoil, liquidity risk has become a big talking point. As certain Swedish fixed income funds, which were advertised as safe investment options, closed for a few trading days in March of 2020 due to the extremely high stress on the market, questions about how illiquidity a↵ects risk and return were asked. There has been plenty of previous research on the subject and it all shows that a liquidity risk premium is present. However, most of this research has been done on stocks which is a relatively liquid type of asset and indicates that liquidity risk might be much more problematic for less liquid assets, such as the ones traded on the OTC-market. OTC data from the U.S. market is publicly available on the Trade Reporting and Compliance Engine and a data set containing around three million transactions over two years is used in this study. To find a suitable liquidity measure for the sample data at hand, a multiple linear regression is made for three different and widely used liquidity measures as dependent variables and known liquidity factors as explanatory variables. The measure is then incorporated into return models as well as analysed in times of stressed market. When incorporating the best liquidity measure into return models, it improves the results significantly which suggests that the bonds are traded at a premia. Finally, there is a clear increase in illiquidity as the volatility on the market increases which gives further understanding as to why the Swedish funds had to close.