Rippling effect of liquidity risk in the sovereign term structure

Abstract

Purpose

The study attempts to identify the linkages in the term structure of illiquidity and the impact of global and domestic factors on sovereign bonds in emerging Asia. The objective of the study ensues on defining the direction of illiquidity spillover across bonds of varying tenors.

Design/methodology/approach

This study explores the joint dynamics of contemporary liquidity risk premia and its time-varying effect on the term structure spectrum using the Diebold and Yilmaz (2012) spillover framework.

Findings

A substantial relationship was found to exist between the liquidity of bonds with closer terms to maturity. The macroeconomic environment primarily impacts the liquidity of 10-year bonds, and they spiral down to the subsequent bond liquidity, exhibiting a rippling effect. The authors further show that the direction of liquidity shock transmission is from long- to medium- and thence to short-term bonds. Among the global factors, foreign investments and S & P 500 VIX significantly affect the liquidity of 10-year bonds.

Research limitations/implications

The study has several implications for academicians, policymakers and domestic and global investment professionals. The drivers of liquidity risk and the transmission across the term structure help investors in designing efficient portfolio diversification strategies. The results are relevant for cross-border investors in the valuation of emerging Asian sovereign bonds while deciding on asset allocations and hedging strategies. The monetary regulators strive on a continuous basis to improve the liquidity in sovereign bond markets in order to ensure efficient funding of development activities. This study finds that short-term bonds are more liquid than long-term bonds. Their auction framework with higher series of short-term bond issues helps to provide the required liquidity in the markets.

Practical implications

The term structure of illiquidity is upward sloping, inferring a higher underlying liquidity risk of long-term bonds compared to short-term bonds. This finding suggests that a higher representation of short-term bonds in the auction framework helps to enhance the overall market liquidity.

Originality/value

This study offers insights into the debate on the shape of the term structure of illiquidity and the point of origination of liquidity shocks. Further, the direction of spillover across a wide spectrum of bonds is also demonstrated.

Citation

Anthony, R. and Prasanna, K. (2023), "Rippling effect of liquidity risk in the sovereign term structure", Journal of Risk Finance, Vol. 24 No. 4, pp. 503-522. https://doi.org/10.1108/JRF-05-2022-0119