The term structure of bond liquidity: Evidence from the UK government bond market

The purpose of this thesis is to study various aspects of the liquidity term structure (in other words how the liquidity of bonds of different maturities differ) of government bonds and its implications on bond pricing, using the government bonds of the United Kingdom as an example. In addition, I study whether bond liquidity is affected by macroeconomic factors, the causality of that relationship, and whether the behavior is dependent on the maturity of the bond and if it is more pronounced in certain special periods. The data includes all the conventional bonds issued by the UK government (referred to as Gilts) outstanding during the period June 1996 to June 2012. This amounts to 108 individual bond issues and 170,550 bond-day observations. I conduct several OLS regressions to test for maturity, bond run status (whether or not the bond is the most recent issue of its maturity class) and pricing effects as well as several Vector Autoregression analyses (VAR) to test for intertemporal effects between macroeconomic factors and bond liquidity. The results indicate that a liquidity term structure does in fact exist for Gilts, with the short maturity bonds on average being more liquid than their longer maturity counterparts. The variability in liquidity between individual bond issues also varies in time - there is more extremity in both liquid and illiquid bonds during crisis periods. Contrary to expectations, bonds of different run status are not found to carry liquidity differences. The data also indicates that illiquidity is priced, with illiquid bonds earning a positive next day return. In line with the hypotheses, bond liquidity seems to be influenced by macroeconomic shocks, as especially the TED-Spread, Term-spread, stock market returns and stock market volatility are found to Granger-cause next day liquidity