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Liquidity Risk and the Pricing of Sovereign Bonds in Emerging Markets

This paper examines the role of the liquidity in the pricing of sovereign U.S. dollar bonds in emerging markets. We extend Acharya and Pedersen’s (2005) liquidity-adjusted capital asset pricing model to the bond market and find that both liquidity level and multiple liquidity risks are priced factors for the expected excess return of U.S. dollar bonds issued by developing countries. The combined effects of liquidity risk and liquidity level can explain as much as 1% per annum extra yield spread for the countries that have higher liquidity betas. Countries which have a high correlation with the global market (or U.S. stock market) have higher required bond returns than low correlation countries. The liquidity factor helps explain the credit spread puzzle of high yields. Our empirical results also support a flight to liquidity across the studied countries and are robust to controlling for bond characteristics and the U.S. risk factors.