What is the illiquidity premium?

IMAGINE TWO bonds listed on different exchanges that are otherwise identical. The risk-free rate of return is 2%. Investors hold bonds for an average of one year. A central bank acts as market-maker, supplying cash on demand for bonds. To cover its costs, the price the central bank pays (the bid) is a bit below the fair value of a bond, which is the price it requires buyers to pay for it (the ask). The bid-ask spread is the cost of trading. For A-bonds it is 1%. For B-bonds, which are listed on an inefficient exchange that charges higher fees, it is 4%.

What is the yield on each bond? It varies with trading costs. Investors on average make one round-trip sale-and-purchase a year. So the yield they demand on A-bonds is 3%. That includes the risk-free rate of 2% plus 1% compensation for trading costs. By the same logic, the yield on B-bonds is 6%. The extra 3% return required on the harder-to-trade security is known as the illiquidity premium.

Illiquidity matters less if investors have longer horizons. A pioneering paper by Yakov Amihud and Haim Mendelson, published in 1986, posits that investors with the shortest horizons hold securities with the lowest trading costs; and bonds that are relatively illiquid are held by long-term investors, who can spread the higher trading costs over a longer holding period. In principle patient investors can reap a reward from illiquidity. But in practice the risks that go with it often prove to be bigger than many investors had expected.

In our simple example, fees are the friction that makes one security costlier to trade than another. But there are other features intrinsic to the securities themselves that make them more or less liquid. The shares of big companies, such as Apple or ExxonMobil, are traded cheaply in seconds, because they are part of a big pool of identical securities. Buy and sell orders can be effortlessly matched on electronic order books. In contrast, a company may have bonds of several maturities. So corporate bonds are intrinsically less liquid than stocks.

In markets for very specialised assets, finding a suitable buyer or seller is costly. A wider bid-ask spread is needed to compensate for these search costs as well as for the risk of prices moving in the meantime. It also takes costly effort and skill to appraise the value of idiosyncratic assets. There is a greater chance that your counterparty knows more about the asset’s true value than you do; so you may end up buying a lemon or selling a hidden gem. Such risks add to the cost of trading less liquid assets and to the illiquidity premium that investors require to hold them.

Most assets are somewhat illiquid. Houses can take several months to sell. A piece of fine art might not trade for decades. Some kinds of investments, such as limited partnerships in private-equity or venture-capital funds, require capital to be locked up for several years. Secondary-market trades are rare; where they occur, they are at predatory discounts. The liquidity cost of holding such thinly traded assets cannot usefully be represented by a bid-ask spread. It is more helpful to think of lockup as incurring an opportunity cost. Liquidity affords options; and illiquidity constrains them. An illiquid asset cannot easily be sold to meet unexpected spending needs (say, medical expenses) or to take advantage of better investment opportunities.

Liquidity varies over as time as well as between assets. It relies on the capacity of private-sector traders and arbitrageurs to supply it. That varies. In good times, it is abundant. Asset prices are on a generally rising trend so market-makers find it easy to borrow to finance their stock of securities. But in bad times, trading liquidity dries up. In extreme cases, such as the 2008-09 financial crises, there are self-perpetuating “liquidity spirals”: market-makers take losses on their stockholdings; they are forced to sell assets to preserve their cashflow; and that in turn drives prices lower, further impairing their ability to trade securities.

At such times a lot of investors who were intent on picking up an illiquidity premium discover that they are far less patient than they had believed themselves to be back when liquidity was plentiful. The possession of cash or the ability to raise it quickly is especially valuable in recessions. The skilful are able to pick up assets cheaply that others have been forced to sell. A short-horizon investor won’t buy such assets, for they might become even cheaper. But a truly patient investor who can wait for the payoff is able to step in—as long, of course, as he is liquid.■