Liquidity Premium in the Eye of the Beholder: An Analysis of the Clientele Effect in the Corporate Bond Market

This paper examines how liquidity and the heterogeneous liquidity preferences of investors interact to affect asset pricing, known as the liquidity clientele effect. We use corporate bond holdings by insurance firms as well as measures of corporate bond liquidity to quantify investors' liquidity preference. We find a wide dispersion of liquidity preference across investors. Such liquidity preferences persist over time and, importantly, are related to characteristics associated with investment horizons. Further, among corporate bonds heavily held by investors with strong preference for liquidity, there is a large liquidity premium effect- namely, bonds with higher illiquidity command higher yield spread; however, the liquidity premium is substantially attenuated among bonds heavily held by investors with a penchant for illiquidity. Our findings provide direct evidence of the liquidity clientele effect, a long-standing conjecture in the asset pricing theory of liquidity.