Lesson 6 of 7 · 12 min
Inside the spread: credit and liquidity
A corporate bond's yield is a government benchmark yield plus a spread, and that spread pays for credit risk, market liquidity risk and possibly taxes; the liquidity part can be measured from bid and offer yields.
In short
- Benchmark yield (default-risk-free) = real rate + expected inflation. The yield spread on top compensates for credit risk, market liquidity risk and possible tax effects.
- Market liquidity risk: the price you can actually trade at may differ from the quoted price; the bid-ask spread is its gauge.
- Liquidity risk is higher for issuers with less debt outstanding, bonds that trade less often, and lower credit quality.
- Liquidity spread = yield at the bid price − yield at the offer price. Credit spread = yield spread − liquidity spread.
- In crises, liquidity dries up, bid-ask spreads widen and stress spills over into other segments.
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