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We propose an option approach for pricing bond illiquidity that isreminiscent of the celebrated work of Longstaff (1995) on the non-marketabilityof some non-dividend-paying shares in IPOs. This approach describes a quitecommon situation in the fixed income market: it is rather usual to find issuersthat, besides liquid benchmark bonds, issue some other bonds that either areplaced to a small number of investors in private placements or have a limitedissue size.  We model interest rate and credit risks via a convenient reduced-formapproach. We deduce a simple closed formula for illiquid corporate coupon bondprices when liquid bonds with similar characteristics (e.g. maturity) arepresent in the market for the same issuer. The key model parameter is thetime-to-liquidate a position, i.e. the time that an experienced bond tradertakes to liquidate a given position on a corporate coupon bond. We show thatilliquid bonds present an additional liquidity spread that depends on thetime-to-liquidate aside from bond volatility.  We provide a detailed application for two issuers in the European market.

A closed formula for illiquid corporate bonds and an application to the European market