The Liquidity Service of Sovereign Bonds

Abstract

This study explains theoretically why sovereign securities are desirable in improving liquidity for securities markets in emerging-market economies. When systematic risk is high and information is costly, there is an information externality for a firm to issue public securities. As a result, either the number of firms entering securities markets is too low or the amount each firm issues is insufficient for security prices to convey information. By contrast, sovereign securities stimulate information production and thus liquidity by making informed trading more profitable. This study also examines empirically the liquidity service of sovereign bonds on corporate bonds for six emerging-market economies. The test results indicate that a new sovereign issue, on average, lowers the bid-ask spread of corporate bonds by 22.1 basis points, from a mean level of 165 basis points; decreases corporate bond spread over treasury by 32.2 basis points, from the mean level of 496.3 basis points; and reduces the correlation between returns on corporate bonds and the corporate return index by 0.106, from a mean level of 0.385.