The Impact of Liquidity on Bond Pricing - A study comparing municipal bonds and government bonds in the Swedish market

Abstract: In this study, we find that liquidity impacts bond pricing in the Swedish market. Specifically, we investigate the impact of liquidity by examining the yield spread between two bonds that generally differ in liquidity: Swedish municipal bonds issued by Kommuninvest and Swedish government bonds. We use the bid-ask spread as a measure of liquidity and find that a larger bid-ask spread of the Kommuninvest bond is associated with a larger yield spread. In addition, we evaluate whether the bonds we study can be used to isolate the impact of liquidity on bond pricing. Liquidity is a multidimensional and complex concept, which makes it difficult to capture in its entirety with liquidity measures. In efforts to avoid the reliance on measures, previous studies of the U.S., German and French markets show that pricing differences due to liquidity can be isolated by comparing the yields of two bonds that are considered equivalent in all regards except liquidity. We build on this method by being the first to evaluate whether municipal bonds which are guaranteed by the local government sector can be used for this purpose. However, in our comparison of Kommuninvest bonds to Swedish government bonds we find that credit quality differences impact the yield spread. Hence, we conclude that the Kommuninvest bonds cannot be used in a comparison with Swedish government bonds to isolate the impact of liquidity.