Ebook Internal Liquidity Risk in Corporate Bond Credit Spreads
With the emergence of the rapidly growing credit and credit derivative markets, the issue of understanding the determinants of corporate yield spreads is of increasing importance in credit risk management. Considerable empirical efforts have been devoted to this fundamental issue. Most of them base on structural models which contain comprehensible economic intuitions and are able to study the effects of macroeconomic conditions and firm specific features on credit spreads. Although most of them support that the Merton type structural models are capable of explaining credit spreads to some extent, few conclude that the cross-sectional behaviors or dynamics of credit spreads could be captured largely by them.
Among those empirical efforts, Collin-Dufresne, Goldstein, and Martin (2001) found traditional credit models explain only about 25% of the variation in credit spreads and the unexplained portion is mostly driven by an unknown common factor. Eom, Helwege, and Huang (2004) find that the predicted spreads of the original Merton model are too low while most of the others over-predict spreads on average. They also find the newer models still suffer from underestimation problem on credit spreads of safer bonds. Campbell and Taksler (2003) utilize panel data of the late 1990s to explore the effect of equity volatility on corporate bond yields and find that idiosyncratic firm-level volatility can explain as much cross-sectional variation in yields as credit ratings can. Covitz and Downing (2002) use a simple liquidity indicator, current ratio, to explain yield spreads. They find that it can explain very short-term spreads while the explanatory power for long-term spreads is rather weak. Several recent studies lay stress on the non-default components in corporate bond yield spreads. Longstaff, Mithal, and Neis (2005), using credit default swaps data, find that the default component represents the majority of yield spreads though the non-default components, such as bond-specific illiquidity and overall liquidity of fixed income markets, do exist. Delianedis and Geske (2001) attribute the discrepancy between the observed credit spreads and Merton’s option based estimates of default spreads to external liquidity effect and market risk factors.
Though researchers continuously address themselves to the determinants of credit spreads, the gap between observed credit spread and its theoretical value is not filled up. The main objective of this study is therefore to explore the effect of corporate internal liquidity on credit spreads in an attempt to solve the unsolved credit spread puzzle. To this end, firstly we investigate the relationship between credit spreads and internal liquidity, which might be a missing piece in the determinants of bond credit spreads. Secondly, after controlling other well-known variables stated in literature, such as leverage, equity volatility, maturity, coupon, issuance amount, we examine whether the effect of internal liquidity in credit spreads is still significant. Lastly, we preliminarily inspect whether internal liquidity could construct a market-wide risk factor accounting for credit spread changes.
Corporate credit risk can be classified into two categories, short-term and long-term credit risk. Long-term credit quality depends on the growing potential of a firm’s future net worth while short-term one relies upon its capability or liquidity reserve to meet its short-run payment obligations. According to previous researches, Merton type models tend to underestimate credit spreads, especially for short-term or safer bonds. This conforms to general intuitions in that Merton type models assume credit events are triggered when firm value drops below a default threshold. In other words, Merton type models mainly deal with long-term credit risk. Besides, it should be noted that even if a firm’s asset value is still above its debt balance, default events may still occur owing to insufficient liquidity.
Two concepts of liquidity are commonly used in the literature, external liquidity and internal liquidity. The former refers to whether a security is able to be quickly traded with large quantities at low cost and without significantly moving the price. The latter one concerns with the ability of a firm to generate (or maintain) adequate cash flow to service its short-term obligations. There are reasons why internal liquidity may be an important element in credit risk. The major purposes of a firm to retain liquidity are to meet the needs of near-term expected and unexpected net cash outlays. The latter, for example, could be unanticipated investment opportunities or unexpected expenses.
With insufficient liquidity reserve, a firm may have to delay payments, sell assets, forgo profitable investment projects, or obtain external financing at unfavorable terms. Because liquidity crunch brings all these detrimental effects on corporate operations (or values) and therefore credit condition, it is naturally for us to postulate that internal liquidity factor plays an important role in the determinants of corporate bond credit spreads.
In our empirical analysis, we employ an internal liquidity measure developed by Liao and Chen (2005) which is able to incorporate dynamics of corporate liquidity and to provide a straight indication of solvency risk of a firm. Our empirical results show that the corporate internal liquidity plays an essential role in explaining credit spreads of corporate bonds. More specifically speaking, internal liquidity reveals significantly supplementary information about corporate credit condition in addition to credit rating and other theoretical factors implied by structural models, and its effect on credit spreads is substantial. In our time-series analysis, we also find that a market solvency state variable which indicates market-wide corporate internal liquidity risk condition could strongly explain the credit spread dynamics.
The remainder of this paper is organized as follows. In section II, we introduce the methodology of measuring corporate internal liquidity. In section III, we describe the data and discuss the proxies used. In section IV, we present and analyze our empirical results. Finally, we conclude the study in section V.
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