What determines the yield differentials between bonds? Even though research has shown that the moments of bonds’ return distribution and liquidity typically both play a role, we still understand imperfectly the relative importance of these two determinants and their possible interactions.
The European Monetary Union (EMU) offers a particularly good arena to examine these issues and sharpen our understanding, because in the euro area we can observe bonds issued by several sovereign issuers, without the complications arising from different currencies and different bond conventions, but with variation in liquidity. Even though since EMU’s inception in 1999 yields on euro-area government bonds converged significantly, these bonds are still not regarded as perfect substitutes by market participants: non-negligible differences in yields across countries have remained, to different extents for different issuers and maturities, and they fluctuate over time. Even the bonds issued by AAA-rated issuers are not regarded as perfect substitutes, so that for example French bonds traded in the cash market are not seen as a perfect hedge for positions in Bund futures.
A possible reason for these persistent differentials is persistent risk differences. Different sovereign issuers are perceived as having different solvency risks, in spite of the provisions of the Stability Pact. A second possible explanation is liquidity. This is indeed the explanation that is often advanced by practitioners.
However, a look at the time-series behavior of Euro-area yield differentials suggests that neither one of these two factors in isolation is likely to provide the full answer. First, as shown below, the yield differentials relative to the German Bund tend to fluctuate together, much more than measures of liquidity, such as bid-ask spreads, do. This suggests that liquidity alone cannot be the full answer, and that there must be other factors driving the differentials’ time-series behavior. Such factors are likely to be related to international investment opportunities or global risk perceptions. For instance, even if the default risk of the Italian and French governments relative to the German one were very stable over time, a changing world price for risk could induce the implied yield differentials to fluctuate together. But this cannot be the full story either. Sizable yield differentials have been observed for several years even within the group of AAA-rated euro-zone countries: as late as 2002, 10-year AAA-rated Finnish debt yielded on average 20 basis points more than the 10-year German Bund. This suggests that indeed liquidity differences may play a role, as practitioners claim.
To analyze these issues, we develop a simple asset-pricing model with exogenous transactions costs and endogenous liquidity demand. The model is kept deliberately simple in order to isolate the implications of our key as sumption of endogenous liquidity demand. The most important insight of our theoretical analysis is that liquidity matters for pricing, but that it interacts with aggregate factors in a way that is different from what traditional CAPM-like asset pricing models would predict.
Our model is based on the idea that the demand for liquidity responds both to the magnitude of trading costs and to the availability of outside investment opportunities. First, investors are less inclined to trade securities with larger trading costs. Second, they are less likely to liquidate securities when outside investment opportunities are less attractive, a situation which is assumed to coincide with increased aggregate risk. As a result, when risk is expected to increase, investors’ demand for liquidity abates, and the premium they place on more liquid securities declines. Therefore, although in general investors value liquidity, they value it less when risk increases.
Download
PDF Ebook How Does Liquidity Affect Government Bond Yields?
