The Pricing of Liquidity Dimensions in Corporate Bonds

Kyle (1985) and Harris (2003) define three dimensionsof liquidity – cost, depth, and time. This study is the first to examine the non-default component of corporate bond yield spreadsin order to determine the importance of these three dimensionsto investors. We find that while illiquidity premia in bonds varies with each individual dimension, the cost dimensionis the biggest contributor to illiquidity premia, followed by the time dimension, and lastly, depth. We also examine whether market-wide or only bond-specific liquidity measures affect the value of corporate debt, and find that not only do market-wide liquidity measures affect the value of debt, but they are actually more important than bond-specific measures. Finally, we examine whether the non-default component of yield spreadsis comprised solely of the state tax and illiquidity premia.