The Bond Coupon’s Impact on Liquidity

Abstract

Corporate bond investors are compensated for liquidity and counterparty risk in the yield received in excess of the credit premium and risk-free rate. This article shows that the liquidity premium as a hedge against uncertain future states is determined by the ratio of excess coupon payments after paying for credit protection to the capital gain realized after hedging interest rate risk. The liquidity premium increases with the time that investors must wait for compensation. The results suggest that the way in which investors receive compensation for liquidity risk is a more significant determinant of the liquidity premium than turnover.