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Latent Liquidity and Corporate Bond Yield Spreads

Corporate bonds are amongst the least understood instruments in the US financial markets. This is surprising given the sheer size of the US corporate bond market, about 5.3 trillion dollars out standing in June 2006, which makes such bonds an important source of capital for US firms.

These bonds carry a risk of default, and hence command a yield premium or spread relative to their risk-less counterparts. However, the academic literature in fi nance has been unable to explain a signi ficant component of corporate bond yields/prices in relation to their Treasury counterparts, despite using a range of pricing models and calibration techniques.

Prior studies have noted that although default risk is an important determinant of the yield spread, there are other factors such as liquidity, taxes, and aggregate market risk variables (other than credit risk) that may also play a signifi cant role in determining the spread. Of these other factors, it has been conjectured that liquidity e effects have a large role to play in the pricing of corporate bonds. Unfortunately, the non-default component of corporate bond yields/prices or CDS-bond basis (the di fference between the CDS price and the corporate bond yield) has been in adequately studied, largely due to the paucity of data.

In particular, the absence of frequent trades in corporate bonds makes it difficult to compute market micro-structure measures of liquidity based on quoted/traded prices or yields to measure liquidity, as has been done in the equity markets. It is difficult, therefore, to measure the liquidity of corporate bonds directly. Consequently, it is a challenge to directly study the impact of liquidity on corporate bond yields and prices, thus leaving the discussion of corporate bond spreads somewhat incomplete.

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Latent Liquidity and Corporate Bond Yield Spreads