The South African Reserve Bank has published a Working Paper presenting an arbitrage-free dynamic term structure framework that separately identifies liquidity and credit risk premia from panels of bond prices. Applying the model to South African government bonds, the authors find that liquidity and credit risk premia are both sizable and only weakly correlated, indicating that liquidity stress and credit stress can be distinct drivers of sovereign bond pricing. The five-factor model extends an arbitrage-free Nelson-Siegel structure (level, slope and curvature) with a bond-specific liquidity factor and a common credit risk factor following a square-root process. Using prices of 31 fixed-coupon South African rand government bonds over a monthly sample from 31 January 2000 to 29 February 2024, the combined liquidity-and-credit specification achieves a tight fit (root-mean-squared error below 4 basis points in yield terms). Estimated average liquidity premia are about 55 basis points (standard deviation 62 basis points) with spikes around the global financial crisis and early 2020, alongside an upward trend late in the sample; average credit risk premia are about 118 basis points (standard deviation 39 basis points) and rise sharply during 2023 to exceed 300 basis points by February 2024. The two premia series have a low negative correlation (about -19%). Regression results reported in the paper link lower liquidity premia to higher pension fund holdings and higher foreign participation, while increases in outstanding bonds relative to nominal GDP tend to push liquidity premia higher; for credit premia, the foreign-held share is the most consistently significant (negative) correlate, and the paper characterises South Africa’s priced sovereign credit risk as largely idiosyncratic.
South African Reserve Bank 2025-01-09
South African Reserve Bank publishes working paper on jointly estimating liquidity and credit risk premia in government bond prices
The South African Reserve Bank's Working Paper introduces an arbitrage-free dynamic term structure model to distinguish liquidity and credit risk premia in South African government bonds. The study finds both premia significant yet weakly correlated, with liquidity and credit stress as distinct pricing drivers. Applied to 31 fixed-coupon bonds, the model shows liquidity premia averaging 55 basis points and credit risk premia averaging 118 basis points, with notable increases during financial stress periods.