Essay: Green Bonds

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  • Green Bonds
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1. Introduction
Demographic change, increasing natural resource demands and urbanization have had critical roles in the enhancement of climate change at a global scale (Satterthwaite, 2007). The resulting climate change-generated hazards, carry uncertainty about the magnitude, timing and distribution of climate impact (Wiltshire, 2014). This presents a challenge for governments and nations and thus increases the significance of taking environmental aspects into account. A major step towards greener economies was taken in 2015 by establishing the Paris Agreement, with the central aim to strengthen the global response to the threat of climate change and the ability of countries to deal with the impacts of climate change (United Nations, 2015).

Furthermore, governments, companies and investors are increasingly acting on environmental issues such as climate change by instating legislation, changing business models and policies and by revising investment processes. The Deutsche Bank (Borysova & Stobbe, 2015), one of the largest financiers of renewable energy worldwide, reports that:

• 138 countries have renewable energy targets and 66 countries have feed-in tariffs

• Over 40 national and 20 sub-national jurisdictions covering 20 percent of global emissions have either implemented or are considering mechanisms that price carbon emissions

• The EU proposed changes to its carbon market as well as a 2030 emissions reduction target to address the oversupply in carbon allowances caused by the recession

However, these measures are likely to be inadequate in order to realize the desired environmental policy objectives in sectors such as agriculture, transport, power and water according to official expert bodies (Zuckerman & Varadarajan, 2012). This is predominantly due to the fact that green technologies require investments of considerably large sizes early on in the development stage, resulting in a common notion that suggests that green projects are riskier ventures as compared to conventional investments, and not always commercially viable from an investors point of view (Lam & Law, 2016). This cost gap between conventional and green investments has been justified and filled by the public sector up to a certain extent through policy-support measures as described above, while the private sector mainly sources just some green finance. In the long run however, financing green investments via public institutions will not be feasible considering the current economic climate (Murray, Cropper, Chesnaye, & Reilly, 2014). An alternative source of green finance would be to initiate green bonds, which is regarded as a tool that could help source renewable energy, transit systems and water infrastructure for the public sector, while at the same time incentivizing the private sector to take a more active role in this industry (International Finance Corporation, 2016).

1.1 What is a Green Bond?

In essence, a green bond is a security that, in addition to its characteristics of conventional bonds, is designed to finance projects that offer environmental benefits (The World Bank, 2015). Theoretically speaking, the only way green bonds will be widely accepted as a source of renewable energy project financing is if this debt instrument is modeled on existing ‘vanilla’ bonds as accurately as possible (Mathews & Kidney, 2012). In order words, the structural features of green bonds must be in line with those of conventional bonds. It speaks for itself that in order for green bonds to succeed, the investors of such bonds need to make a return while exposing themselves to a level or risk that does not exceed that of a conventional government and corporate bond market. Therefore the energy projects, which are financed with the proceeds of the green bonds, need to be capable of generating a sustainable and regular income stream by which means its investors will realize their returns. The assets backing the green bond issues, in this case the renewable energy projects, need to be credible and government guaranteed, the same goes for conventional bonds (Bate, Bushweller, & Rutan, 2003). However, there is one striking difference with regard to green bond structures as compared to the ‘vanilla’ bonds they intend to mimic, the former favors a longer maturity whereas the latter associates longer maturity with higher risks. The main reason behind this is that initially, renewable energy projects entail huge amounts of investments and will therefore be at a loss-making stage in its beginning phase, however as time progresses these projects make higher profits as compared to fossil fuel energy projects (Mathews & Kidney, 2012). The trade-off lies between maturity and risk; from an investors point of view the longer the maturity, the more risk the investment entails. However, from a renewable energy project promoter’s perspective, the longer the time to maturity, the greater the chances are for revenues to overrule the initial costs that had to be made.

1.2 Motivations and Purpose

From the perspective of the market, which includes both the issuer as well as the investor, there are potential benefits from investing in green bonds. An issuer’s motivation can be due to financial and marketing reasons. As will be explained in further sections, issuing green bonds could lead to cheaper financing, but also promote the company as a socially responsible firm, eventually creating a bigger market for the firm’s bonds. Investors on the other hand are mainly concerned with returns. In a world where investors have started to place a significant price on environmental risks, portfolios that are largely invested in carbon-intensive industries are penalized. Hence, the growing impact of carbon risk exposure on portfolios can be costly. Investors can decarbonize their portfolios by means of diversification through green bonds, which may provide protection versus a bond portfolio that does not take environmental factors into account.

The transition to low carbon development and climate resilient growth has resulted in development banks, governments and private companies to raise capital for green investments, mainly through green bonds (Kidney, Giuliani, & Sonerud, 2017). It is estimated that a total of USD 53tn in green investments are necessary by 2035 to keep global temperature rise this century below 2 degrees Celsius (Boulle, Frandon-Martinez, & Pitt-Watson, 2016). The current rate of investment however is much lower than this, which creates urgency among governments and other policy makers to increase such investments. The underinvestment is firstly due to a lack of transparency between the green bond issuer and potential investors, because of which investors are incapable of assessing the risk profile of investment in green bonds. Secondly, as of now, the ratings of green bonds still heavily depend on the balance sheets of the issuing firms rather than the performance of the green investments. Furthermore, investments in green projects are still a relatively new concept. Thus, such projects are still in the experimental phase and issuers associated with these projects are considered less mature. Combining the fact that the performance of green projects are not taken into account while rating the bond and that the projects that are financed with these bonds are less mature, issuers of green bonds are perceived as less mature firms with an unclear risk profile of green bonds and ultimately having a higher credit risk.

Since the investment in green bonds (from both issuer as well as investors perspective) is considered to be risky, the purpose of this thesis is to understand the source of risk in the green bond market. In the case of bonds, the level of risk is translated into the yield spread of the bond, that is, the spread of the bond in question over its government benchmark. Many believe tha
t the default risk determines this yield spread, however the default risk can be seen as an exogenous source of risk as it also hugely depends on operating policies that are heavily influenced by economic circumstances (Utz, Weber, & Wimmer, 2016). The yield spread however, also has a non-default component, namely liquidity. Since liquidity is mainly associated with transaction costs and adverse selection of private information of market participants this can be regarded as a more endogenous source of risk (Bekaert, Harvey, & Lundblad, 2007). There are several researches that have concluded that default risk alone does not explain variation in bond yield spreads. Since, green bonds are still a relatively new concept, and credit ratings are only based on information from the balance sheet rather than the underlying projects itself, it would be fruitful to analyze the non-default component of the yield spread.

1.3 Research Question and Hypothesis

The main question that is proposed to address in this thesis is:

Does liquidity have a significant effect on the variation in the green bond yield spread?

In order to answer this question, this paper tries to establish a more empirical relationship between liquidity and green bond yield spreads. In this thesis, liquidity is defined as the action of trading liquidity with ease. Trading costs, information asymmetry, search friction, inventory risk and adverse selection costs result in illiquidity (Amihud, Mendelson, & Pedersen, 2005). The liquidity measures that are employed in this thesis are the bid-ask spread, percentage of zero- trading days (%ZTD) and Amihud’s illiquidity measure (ILLIQ) While the former is a more commonly utilized measure of liquidity, the latter two are increasingly being used as a liquidity proxy in a number of empirical studies.

The maintained hypothesis is that liquidity does have a significant impact on the green bond yield spreads. According to theory, investors require compensation for bearing risk, thus when this holds, costs of illiquidity should affect bond prices through a positive effect on the yield spreads. Analyzing a comprehensive sample of green bonds, this thesis finds that liquidity measures are significantly positively related to the green bond yields spreads when credit rating data is included in the regressions. A 1 percent increase in the % ZTD or ILLIQ measures lead to an increase in the yield spreads with 122.53 and 287 basis points respectively.

This thesis contributes to the debate on the sources of risk within the green bond market, which are currently still rather ambiguous. By knowing the risk factors that hamper investment in the green bond market, policy makers will be able to effectively reduce barriers that exist within this market and issuers can reduce their sources of illiquidity and ultimately achieve cheaper means of financing with green bonds.

1.4 Outline

The remainder of this paper is organized as follows. Section 2 discusses previous literature on green investing and bond theory, section 3 describes the elimination process through which the green bond dataset is constructed and analyzed. Section 4 presents the regression results and cross checks for any potential endogeneity bias. Finally, section 5 concludes.

2. Theoretical Background

2.1 Evolution of the Green Bond Market

The transition to low carbon development and climate resilient growth has resulted in development banks, governments and private companies to raise capital for green investments, mainly through green bonds (Kidney, Giuliani, & Sonerud, 2017). The green bond market kicked off in 2007 with a EUR 600 million Climate Awareness bond by the European Investment Bank (EIB) that focused on renewable energy and energy efficiency (IFC, 2016). Since then, the market has grown rapidly in OECD countries and has a current total value of outstanding green bonds of USD 295.23 billion, over half of which is issued by corporations and public entities according to the Green Bond Database. The main actors in the green bond market can be categorized as issuers, underwriters, external reviewers, market intermediaries (such as stock exchanges), and investors. Civil society, multi-stakeholder groups and policy makers, which promote transparency and disclosure, also play an important role in the green bond market development (Cochu, et al., 2016).

Corporates gain access to additional capital by issuing green bonds, while simultaneously investing in the green standards or their business. By doing so, many would expect that enhanced environmental performance would lead to higher profits. A much-cited study by Hart and Ahuja (1996) analyses the relationship between emission reductions and firm performance in the S&P 500 and indicates that investing in efforts focused on reducing emissions has a positive effect on the firm’s financial performance with respect to cost advantages, higher efficiency and competitiveness. Cost reductions are a result of taking the environmental impact of their production into account. By paying attention to pollution prevention, waste reduction, energy savings, a firm enhances its competitiveness (Bacallan, 2000). Inferences drawn from a sample of leading edge ISO14001 certified companies in South East Asia indicate that greening their supply chain does not only enable firms to achieve huge cost savings, but they also obtain a larger market share, more market opportunities and greater profit margins, all of which contribute to better economic performance of the firm (Rao & Holt, 2005). Additionally, improved environmental performance makes a firm less prone to accidents or legal sanctions, both of which reduce firm specific risk from a stakeholder’s perspective (Sharfma & Fernando, 2008). Reducing risks leads to lower insurance costs and lower interest rates on debt. This in returns lowers the required return on capital and increase the share value. Also, addressing environmental concerns of consumers could motivate them to purchase your products and services, eventually increasing revenues.

In order to determine whether green bonds have the capacity to enhance return value for investors, one needs to examine whether non-financial ESG data lead to better risk and return portfolio characteristics. In today’s knowledge-based economy, impact factors are becoming more important in the evaluation of corporations (Volkov & Garanina). Four decades ago the business atmosphere placed a huge emphasis on tangible assets, in 1975 about 83 percent of S&P 500 market value was generated through plant, property and equipment (PP&E). Nowadays the picture has been completely reserved, the latest surveys illustrate that the value of firms is now mostly generated by intangible assets, such as intellectual property, brand awareness and a company’s standing on social and environmental issues (Ocean Tomo, 2011). When intangible assets are the source of most of the value creation of companies, non-financial data are key factors that ought to be considered during the evaluation process of a company’s stock. Non-financial data aids in assessing risks that sit outside of the company’s balance sheet, but are critical to the financial performance. Therefore ESG ratings could lead to better investment decision-making and augments traditional financial analysis (Snider, 2016).

Issues such as climate change can have a direct financial impact on a company’s performance if it fails to consider environmental and social risks. A research conducted by Breckenridge finds that investment managers are more capable of performing credit analysis and evaluate risk management by considering a broader array of risks; as a result the company now incorporates ESG factors into all its investment decisions. By integratin
g ESG factors into the investment analysis process, managers get a better sense of the quality and character of the corporate borrower (Breckinridge, 2015). Risks stemming from the impact of management’s operational decisions regarding the environment could have a huge impact on portfolio performances. For example, a company that is largely reliant on natural resources is better qualified to sustain their reputation, reduce future costs and avoid ratings downgrades by standing strong on environmental protection. To illustrate this, take Statoil ASA, a Norwegian multinational oil and gas company. The company scores high on the environmental front as they dedicate themselves to spill prevention, emissions and environmental safety, while maintaining their position as an industry leader in carbon intensity. Meanwhile, from a credit perspective, Statoil’s financial leverage is one of the lowest in their respective industry with a net debt to total capitalization ratio of 10 percent (Breckinridge, 2015). Additionally, the same report examined the net income volatility of two groups: (1) the top 100 S&P 500 companies with regard to ESG ratings and (2) all S&P 500 companies. Results suggest that companies in group (1) show less volatility in their earnings as compared to the broader group (2). From a risk mitigation perspective, earnings stability and margins are credit fundamentals when managing investment-grade bond portfolios. An MSCI Ratings Analysis Report of October 2012 found a low positive correlation between its ESG ratings and Moody’s credit rating. The study found a calculated correlation of 0.34 between the two respective ratings, pin pointing on the fact that factors that were considered by ESG ratings were not necessarily incorporated by Moody’s ratings of comparable corporate issuers. Fixed-income securities generally have maturities lasting from 5 to 10 years and therefore entail longer time horizon risks, which may not be accounted for by Moody’s credit ratings. ESG issues might not have material impact in the short run, but will possibly have an effect on a company’s ability to repay its debt over longer periods of time (Snider, 2016).

With great growth potential within the green bond market, there sought to be more clarity considering the definitions and processes related to green bonds. Therefore, a set of guidelines framing the issuance of green bonds were introduced in 2014 known as Green Bond Principles, GBP (IFC, 2016). The GBP are framed by four core components (Use of Proceeds, Process for Project Evaluation and Selection, Management of Proceeds and Reporting) and mainly provide issuers with guidance on launching credible green bonds and aid investors by extending additional information for them to assess the environmental and social impact of their green bond investments. According to these guidelines, green bonds and conventional bonds should not be considered fungible as the latter does not align with the four core components of the GBP (ICMA, 2016).

The four core components of the GBP assist in ensuring the required transparency and accuracy of the information disclosed by issuers to the investors (ICMA, 2016). Firstly, the Use of Proceeds is a legal document that describes the utilisation of the proceeds generated by the security. The document should provide the environmental benefits of the financed green projects, in quantitative terms where feasible. Furthermore, it is plausible that a share of the proceeds are used for refinancing, in such cases the issuers should estimate the share of the proceeds used for financing versus refinancing for each project portfolio. The GBP recognizes several categories of green projects that are supported by the green bond market all addressing key areas of concern regarding climate change (ICMA, 2016). Such categories include, but are surely not limited to the following: renewable energy, energy efficiency (including the production of transmission), sustainable management of living natural resources (such as, sustainable agriculture) and climate change adaption (information support systems consisting of climate observation or early warning systems). The process for project evaluation and selection required issuers of a green bond to outline how a project portfolio fits within the eligible green projects categories recognized by the GBP. In addition, issuers need to obtain an external review of the selected green projects. Green bond investors may also refer to the issuers profile and performance concerning environmental sustainability to assess the issuers quality. The management of proceeds addresses handling of funds that await investment. An issuer ought to disclose the intended operations concerning the unallocated proceeds to its investors. The GBP encourages issuers to use external reviews such as auditors or other third party, to verify and track the allocation of funds from the green bond proceeds. Lastly, issuers should have readily available up to date information on their proceeds for their reporting. This could be in a form of a summary reflecting the main characteristics of a green bond portfolio along with a brief project description, use of proceeds and environmental impact. Due to confidentiality agreements and competitive considerations the amount of information that can be disclosed will be limited, however the GBP recommends qualitative performance indicators where feasible.

As of June 2016 there were four types of green bonds, additional types may emerge depending on the development of the green bond market in the future: Use of Proceeds green bonds, revenue green bonds, project green bonds and asset backed green bonds (ICMA, 2016). The Climate Awareness Bond, issued by the EIB, is a clear example of a “use of proceeds” bond. This is a standard bond of which the debt re-course is entirely on the issuer (Climate Bond Initiative, 2017). In case the issuer is unable to satisfy the agreed upon debt obligation, investors have the right to the issuers liquid assets. Revenue green bonds hold the revenue streams from the issuer as debt re-course, though fees, taxes etc. are the collateral for debt (ICMA, 2016). In the case of project green bonds the credit exposure is linked to a single project. Therefore, the re-course is only to the project’s assets and the balance sheet (ICMA, 2016). Finally, asset backed green bonds are collateralized bonds for which the re-course is to a cohort of projects that have been grouped together. Majority of the green bonds issues are “use of proceeds” or asset backed green bonds (Climate Bond Initiative, 2017).

Despite the recent spike in growth, the green bond market remains just a small fraction of the total bond market. Against this background, the public sector could take up a larger role to support the development of the green bond market. There is however no solid agreement on the extent to which this role will be fulfilled. For instance, take China’s example, according to Tracy Cai, the Chief Executive Officer of Syntao Green Finance, a consulting agency that focuses on sustainable investments in alliance with financial institutions, green bonds constitute 2 percent of China’s bond market (Hirtenstein, 2017). Furthermore, the People’s Bank of China predicts that, on an average, USD 400 billion ought to be invested every year in order to solve issues regarding the environment and climate change (Climate Bond Initiative, 2016). The public sector will only able to cover 15 percent of the total capital needed, therefore private capital is vital.

2.2 Key Challenges

The green bond market faces several barriers to its further evolution and growth. According to the study on the Potential of Green Bond Finance for Resource-Efficient Investments conducted by the European Commission the following are some of the prominent ones (Cochu, et al., 2016).

1. Lack of green bond supply

As investors are becoming more awar
e of the environmental impact of their investments, the demand for green bonds is strong. However, the supply of green bonds is currently not sufficient. The main barrier here is the lack of projects to be re-financed through green bonds. As stated in the study, bonds are primarily refinancing instruments, therefore a sure amount of capital needs to be readily available upfront. In addition to the financing gap, there is also a lack of well-identified bankable green projects. Even the issuance of green bonds increases, it is not certain whether the current demand for the securities will be able to be sustained. Majority of the green bond markets are still considered a niche, investors may refrain from investing as they perceive them as being less liquid than other assets. Furthermore, institutional investors require issue amounts exceeding EUR 200mln in order to be able to invest, currently green bonds are incapable of reaching such amounts.

2. Lack of skills for aggregating small projects

As previously stated, the sizes of green projects are too small to attract large institutional investors. The number of small green projects is however rising. The aggregation of several small projects or the bundling of cash flows in asset-backed securities could possibly attract large investors. The challenge here is that financing institutions lack the ability to assess risks associated with the underlying projects in an adequate manner.

3. Lack of green bonds definition and framework

Currently, the GBP is a reasonably well-developed framework used to label green bonds. Nevertheless, it is a voluntary framework, this implies that there is no monitoring mechanism to ensure compliance and every nation is free to set its own standards. Companies and financial institutions that would otherwise be prospective issuers of green bonds may refrain from actually issuing green bonds, as it is difficult to determine whether a certain asset is eligible to be labeled as green since their reputation is at stake if their interpretation of “green” is challenged. Additionally, the focus on Environmental Social and Governance factors could potentially lead to incremental costs to investors, asset managers and corporations. ESG commitment, reporting and analysis take time and resources to implement. This could drive a company’s attention away from return maximization. A company also takes on the additional responsibility of reporting and is subject to more scrutiny (Desclée, Hyman, Dynkin, & Polbennikov, 2016).

4. Lack of information and market knowledge

A main impediment to the green bond market development is the limited knowledge possessed by the green bond market participants, which can be traced back to the fact that there is a lack of a standardized definition and framework regarding green bonds in general. Potential issuers find assessing green investments and their impacts challenging as this market is still in its incumbent stage and in the process find it difficult to obtain good credit ratings. Good credit ratings are however vital in order to attract large institutional investors, who in particular are bound to strict requirements regarding the qualitative assessment of the financial assets they invest it. Since many (potential) green bond issuers are less mature firms they will be granted lower credit ratings as compared to firms that have a long record of accomplishment in the general bond market. This impedes new market participants with innovational business models to obtain adequate ratings and tap the bond market for financing.

5. Unclear risk profile of green investments

Green investments are characterized by less mature technologies and a lack of sufficient evidence on the performance. Therefore, rating agencies and institutional investors consider the technology risk higher for emerging green investments than for conventional investments in more matured sectors. Many sustainable projects are still in the initial stages, therefore risk assessments is mainly based on the balance sheets of the issuing firms rather than on the projects itself. The lack of clear reporting by bond issuers and poor quality assessment by external reviewers both result in an unclear risk profile of green bonds.

2.3 Bond Theory

In order to increase the green investment rate, investors with a large asset base need to be incentivized to participate in the green bond market. Institutional investors hold the majority position as one of the key participants of the global bond market and own over 80 percent of institutional assets in middle-income countries, they have the resources required to drive and amplify green investments. As an investor, one is likely to invest in bonds that provide the highest return. Understanding the factors drive different bond spreads, gives an insight to why bonds perform differently from one another. In general, returns on the bond market are reflected with the risk involved with a particular bond investment. Investors ought to accept additional risk in order to earn higher returns. There is no clear consensus on which factor is mainly responsible for the credit bond spread, however academics do seem to agree upon the fact that this spread is not solely due to the default risk associated with a particular bond. Other factors that have high explanatory power over the observed credit spread are tax effects, risk premium and liquidity.

In brief terms, a bond, more formally classified as a fixed income security, is a debt instrument issued by public and private institutions in order to raise capital for their activities. In the most generic sense, bonds are issued with three essential components; maturity, which indicates the life of the bond, par value or principal, which is the amount the bondholder will be repaid when the bond reaches maturity and is determined at issuance, and the coupon rate, which is the percentage of par value that will be paid to bondholders usually on annual or semi-annual basis. Thus, bonds are characterized by fixed interest payments and a return of principal at maturity (RBC Wealth Managemen, 2017).

There are various types of bonds, depending on the type of coupons and different redemption features. The interest paid by bonds can be fixed, floating or payable at maturity. In the case of fixed rate bonds, investors receive a fixed interest rate until maturity, whereas holders of floating rate bonds receive coupons that are subject to periodical adjustments offering protection against fluctuations in the market interest rates. In contrast, zero coupon bonds have no periodic interest payments, but are instead sold at a deep discount and are redeemed at the full face value at maturity. Although the maturity is a good indication for how long a bond will be outstanding, some bonds have structures that enable to issuer to redeem them before maturity. This significantly changes the expected life of the investment (Choudhry, 2004). This thesis only to focuses on plain vanilla fixed coupon bonds that are only callable at maturity.

2.4 Yield spread and the Non-Default Component

Based on the bond price and the predetermined coupon, the yield is the actual return an investor earns on a bond. The (current) yield measures the current income an investor receives in relation to the current price of the bond. It is calculated by dividing the bond’s yearly coupon payments by the market value of the bond. Although this measure is appropriate for investors aiming to maximize their current income, it does not take indicate whether investors make a loss or gain when the bond matures or is sold. Therefore the yield is not to be confused with the yield to maturity. The yield to maturity equals all interest payments an investor receives from holding the bond since purchase until maturity plus any gain or loss (depending on whe
ther the bond was purchased above or below par respectively). For this reason, the yield to maturity is considered more meaningful.

The risk free interest rate compensates for the time value of money. Moreover, investors expect to earn some additional return for risk-bearing investments, which is the risk premium. This thesis defines the yield spread as the yield of a corporate green bond minus the yield of a benchmark government bond of exactly the same maturity and currency. It is highly unlikely to find a government benchmark with the exact same maturity as the respective corporate green bond. In most cases, the benchmark yield is interpolated using a benchmark government bond with a lower and another benchmark government bond with a higher maturity. Government bonds are considered to be risk free, and thus the yield spread measures the risk premium for the investment in a risky corporate green bond (Utz, Weber, & Wimmer, 2016).

As stated previously, majority of the corporate bond spread is due to default risk. However, a number of recent studies indicate that neither levels nor changes in the corporate yield spread can be fully explained by default risk determinant. Longstaff (2005) finds evidence of a significant non-default component in corporate spreads that is associated with liquidity and taxes. The study uses the information in credit default swap premia to provide direct measures of the size of the default and non-default components in corporate yield spreads. They find a significant non-default component for 75% of the firms in their sample ranging from 20 to 100 basis points. Tax effects are a weak determinant of the non-default component, whereas measures of individual corporate bond illiquidity are strongly related to the non-default component (Longstaff, Mithal, & Neis, 2005). Another study examines a dataset consisting of investment-grade corporate and government bonds, which are extracted from the Lehman Brothers Fixed Income Database. In this case, of 10-year corporates, 46.17 percent of the difference between spot rates on corporate and government bonds remain unexplained by expected default or taxes (Elton, Gruber, Agrawal, & Mann, 2001).

This thesis will not account for tax factors and solely focus on how liquidity influences variation of the yield spread.

2.5 Yield Spread and Liquidity Risk

Liquidity is as of yet not defined as a single metric, but rather reflects 3 main characteristics of a security marketplace. These are the immediacy of a trade, the ability for an asset to trade quickly in large volumes, and the requirement that an asset’s price mechanisms should not be overly sensitive to the size of traded volumes (Keller, Rodrigues, & Stevenson, 2008). This thesis adapts the following definition of liquidity, which is the ease of trading a security. In a frictionless market, any security can be traded at no cost at any moment in time. Trading costs, search problems, information asymmetry and adverse private information and inventory risk cause illiquidity in the market. Trading costs and search problems influence liquidity by reducing the number of noise traders on the market. When private information exists amongst traders, all players will be skeptic regarding the information that might be withheld on trading a security by their respective counterparty. Then, trading with an informed counterparty will result in a loss. To compensate for this loss, market makers try to gain from trades with uninformed traders by charging a certain bid-ask spread (Amihud, Mendelson, & Pedersen, 2005). Finally, market makers should be capable of providing immediate trades to any trader, and therefore need to build up inventory. Such inventory carries a price risk for which market makers need to be compensated for my higher bid-ask spreads (Utz, Weber, & Wimmer, 2016). Finally, a study covering over 4000 corporate bonds and spanning both investment grade and speculative categories, finds that more illiquid bonds earn higher yield spreads and improvement in liquidity cause a significant reduction in yield spreads (Chen, Lesmond, & Wei, 2007). This suggests that liquidity is indeed priced in corporate yield spreads.

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