Pricing an illiquidity premium in liquid assets

When considering the available investment opportunity set investors should theoretically be rewarded as they move out the risk curve. That is, as an investor moves from the safest asset class, being cash (obviously requires some assumptions), there should be an extra return or premium to reward investors for the extra risk. One such risk is illiquidity risk, the risk that you may not be able to sell at a ‘fair value’ in a timely manner (the idea of ‘fair value’ is also a discussion for another day).

Illiquidity risk tends to be associated most with real assets like property, but anecdotally I have been hearing more about this risk being under-priced in bond markets, particularly lower rated corporate bonds. Dubbed ‘high yield bonds’ they should more aptly be named higher-yield bonds since central banks have driven yields lower across the risk spectrum. In other words, the reach for yield has pushed spreads on bonds with even less investor protection near record lows.

High yield bond investors and investors in general are assuming the US Fed can “pass the camel of massive quantitative easing through the eye of the needle of normalizing monetary policy without creating havoc”. In the event that the camel gets stuck and the Fed causes another market ‘tantrum’, assets classes, like high yield bonds, that now appear liquid may not be liquid in the future, when it is needed most. Think of it like your mobile phone network on New Year’s Eve, everything is working fine until everyone wants to text or call at the same time and suddenly the network jams!