Measuring Bond-Level Liquidity

Abstract

Market liquidity is important for investors, portfolio managers, and policy makers because it affects decision making and portfolio performance. Yet, for all its importance, liquidity is difficult to measure. Although various approaches to measuring systemic, market-wide liquidity have evolved over time, there have been no reliable security-level metrics. The problem is particularly acute for bonds, many of which trade thinly and mostly over the counter. This article describes a bond-level liquidity measure, Liquidity Cost Score (LCS), that fills this void in the fixed-income investors’ toolbox. LCS is defined as the cost of a standard, institutional-size round-trip transaction. It is expressed as a percentage of a bond’s price and can be aggregated across bonds in a portfolio, as well as compared over time. LCS provides investors with a rigorous and consistent metric and facilitates academic research of market liquidity.