Estimating the Liquidity Premium in the Norwegian High Yield Bond Market : An Empirical Analysis of the Norwegian High Yield Bond Market and Its Liquidity Premium in the Period 2009 - 2021

Abstract

We estimate the liquidity in the Norwegian High Yield Bond Market (Norwegian HY) using transaction data from January 01, 2009, to October 05, 2021. We aim to quantify how much investors, on average, require as compensation for the Norwegian HY being illiquid. Hence, our main contribution is estimating the average liquidity premium as a share of the yield spread. The study we carry out starts with estimating liquidity in Norwegian HY with three transaction cost estimators, two price dispersion measures, and one price impact measure. Then, we analyze and compare the liquidity measures descriptively and empirically. Finally, we conduct an empirical correlation study on the yield spread and the liquidity measures to examine how much of the variation in the yield spread that can be explained by illiquidity. We find significant correlations for the liquidity measures with bond characteristics and trading activity variables. This indicates that the relevant variables, on average, can say something about a bond’s liquidity. On the other hand, we also find that the various liquidity measures deviate markedly in their estimates, implying that approximating liquidity in Norwegian HY is a challenging task. Nonetheless, we observe a significant relationship between less liquid bonds and higher yield spreads for four out of six measures. These four measures also describe relatively equal proportions of the yield spread. That is between 20.5% and 26.9%. Thus, we estimate the average size of the liquidity premium in Norwegian HY to be within this interval. These results show that investors in Norwegian HY require a considerable premium for the market’s illiquidity.