Pricing the liquidity spread in the secondary bond market

Abstract

The goal of this work is to analyze and to price the liquidity premium demanded by investors in the trading of corporate bonds in the Brazilian secondary market, based on the bonds' daily yield to maturity. The econometric tests were performed based on a model by Houweling, Mentink and Vorst (2005) applied to the Eurobonds market for the years 1999 to 2001. A five-variable model was implemented to control for other sources of risks, which are determinants of the corporate bonds spread, apart from liquidity. The well-known, two-factor Fama-French (1993) model of fixed income bonds was used to control for credit risk and interest rate risk; the marginal effects were incorporated through individual corporate bond characteristics (rating and duration) and a factor based on the PréxDI rate of the portfolios' duration was included to adapt the model to the peculiarities of the Brazilian bond market. The work took into account four liquidity proxies that are widely used in the literature: issued amount, age of issue, daily number of trades, and bid-ask spread. The model was estimated once for each of the proxies. In order to conduct the regression tests and to price the liquidity premium in the Brazilian secondary bond market, all of the model variables were calculated for each one of the data samples. Then, for each of the liquidity proxies, mutually exclusive portfolios were constructed daily, the corporate bonds being segregated in portfolios in accordance with the liquidity proxy in question, based on the methodology proposed by Brennan and Subrahmanyam (1996). The database, which amounted to 16,083 samples, was based on the daily quotes provided by the Sistema Nacional de Debêntures (the National Debentures System) from May 2004 to November 2006. The null hypothesis that there is no liquidity premium built into the spreads of the bonds traded on the Brazilian secondary market was rejected for all the liquidity proxies analyzed. Depending on the liquidity proxy considered, the liquidity premium in the Brazilian secondary market for corporate bonds ranges from 8 to 30 basis points.