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Credit and Liquidity Risk in Bond and CDS Markets

Now a days, credit derivatives markets provide a standardized alternative to bond markets in taking on and selling off credit risk exposures. This development offers a new approach to one of the most widely explored problems in fixed income analysis the separation of the corporate bond spread into its credit risk and liquidity component.

The corporate bond spread is usually defined as the difference between the bond’s yield to maturity and a given default-free interest rate such as the swap rate or the yield on government bonds of the same maturity. Unarguably, credit risk is one of the spread’s most important determinants, but there is clear empirical evidence that liquidity also has a significant impact. First, financial instruments such as AAA-rated bonds which are practically default-free often trade at a significant positive spread in excess of the yield on treasury bonds.

This spread is mostly interpreted as a liquidity premium. Second, government bonds and mortgage bonds of the same issuer with identical default risk but different issuing volumes are traded in some markets, and they usually differ with regard to their spreads. This spread differential is also attributed to differences in liquidity between the two instruments.

These observations show that the separation of the total bond spread into its credit risk and liquidity component constitutes a central question if an issuer’s credit risk has to be quantified. When observed corporate bond spreads are directly used to estimate default probabilities, neglecting systematic liquidity premia will lead to biased estimates of the true default risk. Therefore, the problem is crucial for the correct pricing of bonds and credit derivatives as well as for the calculation of the economic capital a bank has to hold because of credit risk. However, the identification of the pure credit risk component is difficult since only the sum of the two risk premia can be observed in the market. In addition, an interdependence between credit risk and liquidity cannot be ruled out.

Credit and Liquidity Risk in Bond and CDS Markets