The Determinants of Liquidity in the Corporate Bond Markets: An Application of Latent Liquidity1

The Determinants of Liquidity in the Corporate Bond Markets: An Application of Latent Liquidity We present a new measure of liquidity known as “latent liquidity” and apply it to a unique corporate bond database to discern the characteristics of bonds that lead to higher liquidity. Unlike conventional measures of liquidity, such as trading volume and bid-ask spreads, our measure of liquidity does not use transactional information; instead, it uses information about the ownership of securities to measure the accessibility of a security by a securities dealer. Therefore, our measure has the important advantage of being able to assess liquidity for markets with extremely low trading activity, where transactions data are insufficient to compute traditional measures of liquidity, but where liquidity is still an important issue. We relate our proposed latent liquidity measure to bond characteristics such as amount outstanding, credit quality, maturity, age, optionality and industry segment. In the liquid segments of the market, where trade-based measures of liquidity are available, our proposed measure exhibits similar relationships to bond characteristics as the trade-based measures. However, latent liquidity exhibits greater consistency in terms of its relationships with bond characteristics, over time. In addition, in the illiquid segment of the market, the relationships of our measure to bond characteristics are also similar to what we observe in the liquid segment. This leads us to believe that our measure is a viable measure of liquidity, when trade-based measures are unavailable.