Illiquidity plays a major role in corporate bond markets. While some corporate bonds are traded on a daily basis, many other bonds trade less frequently. The corporate bond market is therefore very well suited to study the price effects of liquidity and several studies have recently examined whether illiquidity affects corporate bond prices. Most of these studies regress a panel of credit spreads on liquidity measures, thus using liquidity as a bond characteristic. A few recent articles analyze whether there is a premium associated with exposure to systematic liquidity risk, but do not include liquidity as a characteristic.
The first contribution of this paper is that we integrate these two approaches. We perform a detailed comparison of the effects of liquidity as a bond characteristic (liquidity level) and various forms of liquidity risk. We do this using a formal asset pricing approach, based on recent models of Acharya and Pedersen (2005) and Bongaerts, de Jong and Driessen (2009). Given that the liquidity level and liquidity risk exposures are strongly correlated across bonds and over time, neglecting either the liquidity level or liquidity risk may lead to misleading conclusions on the effects of these different liquidity measures. Determining which liquidity channel is most important is relevant for several reasons.
First, most theoretical models that generate price effects of liquidity focus on the liquidity level, and not on liquidity risk (see, for example, Vayanos (2004) and Vayanos and Wang (2009)). Second, the extent to which optimal financial portfolios are affected by illiquidity also depends on whether liquidity risk or liquidity levels are priced. Finally, distinguishing these liquidity effects is important for the valuation of illiquid assets (Longstaff (2010)). Our results show that the liquidity level has a strong and robust effect on bond prices, while the effect of systematic liquidity risk is small and mostly insignificant.
Our second contribution is that our liquidity-based asset pricing model sheds light on the “credit spread puzzle”. This puzzle states that credit spreads on corporate bonds are much higher than what can be justified by historically-estimated expected losses and exposure to market risk factors (see Elton, Gruber, Agrawal and Mann (2001) and Huang and Huang (2003)). We show that liquidity effects play an important role in explaining this credit spread puzzle. Especially for high-rated bonds, a considerable part of the expected return can be explained by the illiquid nature of these bonds.
Download
An asset pricing approach to liquidity effects in corporate bond markets
