The on-going global financial crisis had its origins in the US sub-prime mortgage market in 2006-2007, but has since spread to virtually every financial market around the world. The most important aspect of this crisis that sharply distinguishes it from previous crises is the rapidity and degree to which both the liquidity and credit quality of several asset classes have deteriorated. While clearly both liquidity and credit risk are key determinants of asset prices, in general, it is important to quantify their relative effects and, particularly, how much they changed during the crisis. It is also relevant to ask if there are interactions between these factors, and whether these relationships changed substantially in magnitude and quality from prior periods.
In this paper, we study liquidity effects in the US corporate bond market for the period October 2004 to April 2008 including the GM/Ford downgrades and the on-going sub-prime crisis, using a unique data-set covering basically the whole US corporate bond market. We employ a wide range of liquidity measures to quantify the liquidity effects in corporate bond yield spreads. Our analysis explores the time-series and cross-sectional aspects of liquidity for the whole market, as well as various important segments, using panel and Fama-MacBeth regressions, respectively.
Most major financial markets, including those for equity, foreign exchange, credit and commodities, have been severely affected in terms of price and liquidity in the current sub-prime crisis. However, the impact has been disproportionately felt in the fixed income markets, including the markets for collateralized debt obligations (CDO), credit default swaps (CDS) and corporate bonds. An important point to note is that these securities are usually traded in over-the-counter (OTC) markets, where there is no central market place, or even a clearing house.
Indeed, this aspect has come under regulatory scrutiny since the near-collapse of the CDS market, which was an opaque OTC market. It is the OTC structure of fixed income markets that makes research, especially on liquidity effects, difficult as traded prices and volumes are not readily available, and important aspects can only be analyzed based on quotations from individual dealers, which may not necessarily be representative of the market as a whole.
