On the compensation for illiquidity in sovereign credit markets

•We analyze the role of liquidity in the sovereign credit default swap (CDS) market.•Information about illiquidity is extracted from the sovereign CDS term structure.•Illiquidity premium is the reward for trading in the less liquid part of the curve.•Illiquidity risk premia exhibit substantial comovement across countries.•Unidirectional causality from default to liquidity is detected.

This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default to liquidity is detected for the overall market.