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FRM Part I · FRM Exam Part I · Corporate Bonds

Two bonds from the same issuer have identical maturity and coupon. Bond A is a recent USD 2 billion issue with an active dealer market; Bond B is an old USD 150 million issue held mostly by buy-and-hold insurers. Everything else equal, which outcome is most consistent with liquidity effects?

Bond B should have the higher yield. With the same issuer, coupon and maturity, the smaller, tightly held issue is less liquid, so investors require a liquidity premium. Credit risk is identical, so the yield difference reflects compensation for harder and costlier trading.

  1. ABond B has a higher yield, reflecting a liquidity premiumCorrect
  2. BBond B has a lower yield, because buy-and-hold ownership reduces risk
  3. CBoth have identical yields because credit risk is the same
  4. DBond A has a higher yield because large issues are riskier

Explanation

Investors demand extra yield for holding less liquid securities. Bond B is smaller and tightly held, so it is less liquid and should trade at a higher yield despite identical credit risk. Identical yields ignore the liquidity component of the spread.

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