Studies have suggested that credit spreads inthe market have been observed to be greaterthan what can be justified by default and recoveryrates. Explain how by quantifying liquidityspreads, one can obtain a truer measure of creditspreads

What will be an ideal response?

To begin, let us note that liquidity is the flexibility afforded a portfolio manager in rebalancing a portfolio based on expectations. A liquidity measure can be used by a client seeking to create a customized liquid benchmark for credit portfolio managers that it has engaged. The credit issues included in such a customized credit benchmark would be the result of screening all the credit bonds in a broader benchmark so as to include only liquid issues as determined by the liquidity measures. Portfolio managers can use a liquidity measure in several ways.

First, several studies have suggested that historically observed credit spreads (even after adjusting for any embedded option) are greater than can be justified by historical default and recovery rates.A liquidity measure can be used to decompose the observed spread for a credit-risky issue, which is simply referred to as the credit spread, into a liquidity-adjusted credit spread and liquidity spread. This decomposition allows a portfolio manager to potentially enhance return by having a better measure of the true credit risk of an issue and to take an appropriate position in issues whose liquidity is expected to increase or decrease.

Second, in executing trades during a period of illiquidity, monitoring the behavior of a liquidity measure over time can be used to determine what action should be taken at the beginning of a liquidity crisis. Understanding the performance of bonds identified as illiquid over time can provide guidance to portfolio managers as to whether to sell highly liquid bonds (as determined by the liquidity measure) or illiquid bonds.

There have been several proposals for measuring liquidity. One measure is Barclays Capital, the Liquidity Cost Score (LCS), which it defines as "the cost of a roundtrip institutional-size transaction in a bond." For bonds that are quoted in terms of their bid-ask spread (referred to as spread-quoted bonds), the LCS is defined as
LCS = (Bid − Ask spread in basis points) × Spread duration
For example, if a credit-risky bond has a spread duration of 4 and a bid-ask spread of 40 basis points, the LCS is 4 times 40 basis points, which is equal to 160 basis points or 1.6%.

The interpretation of the LCS is as follows: it is the roundtrip cost as percent of the bond's value "of immediately executing a standard institutional transaction." Roundtrip cost refers to the cost of buying and then selling a bond. A standard institutional transaction is for $3 to $5 million of par value. An LCS for a bond of 1.6% trading at a bid price of 85 means that the current immediate roundtrip cost would be 1.6% of the bond's price. A higher LCS value means worse liquidity.

For bonds quoted in terms of price rather than bid-ask spread (referred to as price-quoted bonds), LCS is computed as
LCS = (Ask price − Bid price)/Bid price