How does liquidity affect government bond yields?

We explore the determinants of yield differentials between sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of international risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We estimate a model that predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced for a subset of countries and their interaction with the risk factor is crucial to detect their effect