A liquidity risk premium is an additional return on bonds that are not actively traded. Illiquid bonds cannot be easily bought and sold at fair market value. To compensate investors for this lack of liquidity, illiquid bonds pay a premium.
Bond yield is the sum of the risk-free interest rate, expected inflation, credit risk premium tied to the business of the issuer, maturity risk premium tied to the bond's holding period and liquidity risk premium. The liquidity risk premium increases bond yield and reduces bond price.
Corporate bonds of investment-grade U.S. companies have an average liquidity risk premium of 0.6 percent per annum. By contrast, speculative-grade bonds from small, less-known companies have an average liquidity premium of 1.5 percent per annum.
The liquidity risk premium is the compensation that a lender receives for investing funds in something that is difficult to sell. For bonds, lenders end up paying a lot less for the bond and get higher returns than if they invested their money in a more liquid asset.
U.S. mortgage securities used to be highly liquid. However, at the peak of the 2008 economic crisis, all banks wanted to sell their mortgage bonds, but there were no buyers. As a result, prices on mortgage bonds dropped to artificially low levels, primarily because of a dramatic drop in liquidity.
If demand for certain bonds dries up in response to economic conditions, liquidity premiums rise and bond prices drop. Investors desperate for cash would sell such bonds at a sizable loss. Investors with the capacity to hold or buy the same bonds stand to profit handsomely over time.
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