The Term Structure of Liquidity Premium
Treasury securities are valuable partly because they are liquid. Investors accept lower yields on Treasuries than on otherwise similar but less liquid assets because Treasuries are easier to sell and use in stressful times. This value is called the Treasury liquidity premium. The paper asks how that liquidity value varies across maturities.
Most discussions of liquidity focus on a single number, often at the short end of the market. But liquidity has a term structure, just like interest rates do. A three-month Treasury provides near-term liquidity. A ten-year Treasury provides a stream of liquidity services over a longer horizon. The value of liquidity at different maturities can therefore reveal how investors think about current and future market conditions.
We measure the liquidity premium term structure using the yield spread between Treasury STRIPS and Resolution Funding Corporation STRIPS. Refcorp bonds are guaranteed by the U.S. government, so they are very close to Treasuries in credit safety, but they are less liquid. The yield difference between Refcorp and Treasury securities of the same maturity provides a clean measure of the superior liquidity value of Treasuries.
The first result is that liquidity premia are economically significant across the maturity spectrum. Treasury liquidity is not only a short-term money-market phenomenon. Investors value the liquidity of longer-term Treasuries as well. The term structure of liquidity premium has level, slope, and curvature factors, much like the Treasury yield curve, but it contains information distinct from the yield curve.
The second result is cyclical. The liquidity-premium curve tends to slope downward in recessions and upward in booms. This pattern is intuitive. In bad times, investors care intensely about immediate liquidity, so short-maturity liquidity is especially valuable. In good times, investors price future liquidity needs differently, and the curve can slope upward.
The third result is predictive. Forward liquidity premia predict future short-term liquidity premia and future market liquidity conditions. This means the curve is not only a snapshot of today's liquidity demand. It contains information about expected future liquidity conditions, much as forward interest rates contain information about expected future rates and risk premia.
The paper also studies monetary policy. Liquidity premia affect how policy passes through to corporate financing rates. Interest rate policy and quantitative easing work differently through the liquidity channel. Interest rate changes can be dampened by movements in liquidity premia, while QE can have stronger pass-through because asset purchases directly affect the supply of liquid Treasury securities available to investors.
The main message is that Treasury liquidity is not a vague convenience label. It is priced across maturities, moves over the business cycle, and affects the transmission of monetary policy. The liquidity value embedded in Treasuries can make borrowing conditions change even when default risk is not changing.
This matters for interpreting financial conditions. A low Treasury yield can reflect expectations about future short rates, compensation for risk, or the special liquidity value of Treasuries. Separating these components helps policymakers and market participants understand what bond markets are actually saying. The paper shows that the liquidity-premium curve is one useful way to read that signal.