Joint estimation of liquidity and credit risk premia in bond prices with an application

This paper introduces a novel arbitrage-free dynamic term structure model that jointly accounts for liquidity and credit risk premia in panels of bond prices. While liquidity risk is bond-specific, credit risk is common across bonds and follows a square-root process to ensure nonnegativity and econometric identification. A simulation study confirms the separate identification of liquidity and credit risk. We apply the model to South African government bond prices and document the existence of large and weakly correlated liquidity and credit risk premia. This underscores that liquidity and credit stresses are distinct risks to bond investors.