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Liquidity and Arbitrage in the Market for Credit Risk

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 6.8 trillion dollars outstanding as of June 2009, 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 free counterparts. However, the academic literature in finance has been unable to explain a significant component of corporate bond yields/prices in relation to their Treasury counterparts, despite using a range of structural and reduced form credit risk models.

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 significant role in determining the spread. Of these other factors, it has been conjectured that liquidity effects have an important role to play in the pricing of corporate bonds, and are reflected in the non-default component of their yields, i.e., the portion of the corporate bond yield that cannot be explained by factors related to default risk.

Since illiquid instruments are difficult to trade, investors holding them demand a risk premium that is related to the level of liquidity in the instrument. In the context of corporate bonds, this premium increases the expected return of the bond, in a way that is not directly related to the credit risk embedded in the instrument. In other words, a premium for liquidity can be thought of as a non-default related component of the yield spread.

Unfortunately, the non-default component of corporate bond yields has been inadequately studied, largely due to the paucity of data. In particular, the absence of frequent trades in corporate bonds makes it difficult to compute trade-based measures of liquidity relying 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.

Liquidity and Arbitrage in the Market for Credit Risk