The effects of expected illiquidity and liquidity risk (unpredictable variations in illiquidity) on asset prices have been at the center of a large body of recent academic research. While these studies have made substantial progress in enhancing our understanding of how liquidity affects asset prices, they all have one common feature which is that their analysis has been unconditional in nature. In contrast, casual empiricism suggests that effects of liquidity on asset prices are felt most in an episodic fashion. By and large, such a conditional or episodic role of liquidity in affecting asset prices has not been investigated before, the exception being a recent study by Watanabe and Watanabe (2007) who find evidence supportive of there being a regime switch in the nature of liquidity risk of stock returns.
In this paper, we investigate the liquidity risk of corporate bond returns, focusing on the conditional effects during stress times and on the difference in such conditional effects between high-rated and low-rated bonds. Our novel contribution is to document that the liquidity risk of corporate bonds is highly conditional in nature, especially for junk bonds, and arises primarily during periods of economy-wide stress. In fact, during such periods, the effect of liquidity risk on junk bond returns can be as large as that of default risk itself in terms of economic magnitude. This nature of liquidity risk of corporate bond returns is robust to controlling for other systematic risks, as well as changes in volatility and expected loss over time.
Specifically, we examine the unconditional and conditional sensitivity of monthly U.S. corporate bond returns to liquidity factors over the period 1973 to 2003. The two liquidity risk factors we employ are the price-impact motivated measure for aggregate stock market of Amihud (2002), as calculated by Acharya and Pedersen (2005), and the equally weighted quoted bid-ask spread of off-the-run treasuries, as in Goyenko (2005). In unconditional tests, we investigate the time-series “beta” of corporate bond returns on these liquidity risk factors, controlling for the effect of interest rate and default risk factors (as in Fama and French, 1993). In conditional tests, our primary focus, we allow these liquidity betas to vary over time, specifically to be different in “normal” times versus “stress” times. We adopt a variety of definitions for stress times for the economy combining variables that capture incidence of recession in the real economy and its manifestation in stock markets.
Results from our unconditional tests show that as rating declines, liquidity risk of corporate bond returns increases with respect to both stock-market and treasury liquidity factors, with a sharp increase at the cusp of investment grade and junk grade. Statistically, the liquidity risk of investment grade bonds is insignificant, that of junk bonds is significant, and importantly, the difference in liquidity risks between junk bonds and investment grade bonds is also significant. Overall, these results are consistent with those of de Jong and Driessen (2006). These unconditional estimates of liquidity risk, however, suggest that the economic magnitude of liquidity risk is small on average, especially when compared to the effect of interest rate and default risk.
Our conditional tests are based on a regime-shifting model of betas of junk bond returns on interest rate, default and liquidity risks; there is no shift detectable for investment grade bonds. Data identifies two distinct regimes for junk bond betas, substantial difference across which arise only due to difference in liquidity betas and not in betas of other risk factors. The difference in liquidity betas across regimes is also large from an economic magnitude standpoint: liquidity risks magnify by a factor of three to ten from first to second regime, whereas interest rate and default risks are virtually unaffected. The probability of being in the high liquidity beta regime correlates with macroeconomic variables that one would generally employ to exogenously specify stress times, and this probability also captures some periods that are easy to identify with known stress episodes in the US economy and markets.
In the stress regime, the economic magnitude of liquidity risk of returns is substantially large, almost comparable to that of default risk. A one standard deviation in either of the liquidity factors produces only about a tenth of a standard deviation shock in returns during normal times; during stress times, however, the effect is between one fifth to one third of a standard deviation and the overall effect of liquidity factors is magnified as the two liquidity risks become more correlated during stress times. In contrast, the economic contribution of interest rate and default risks is larger in absolute terms in either regime, but that of interest rate risk falls during stress times whereas that of default risk rises but the shifts in the two effects are smaller across the two regimes and also seem to offset each other.
We show that the findings are robust. First, we allow for a change in expected cash flows (expected loss) on corporate bonds by employing a time-series of expected default frequency and expected loss given default, and allow this change to have differential effect on investment grade and junk bonds in normal and stress times. Second, we control for changes in aggregate stock-market volatility as implied by realized index returns. Third, we replace the Fama and French (1993) model of systematic risk factors with the Merton-model inspired specification of Schaefer and Strebulaev (2006) that employs equity return corresponding to a corporate bond to proxy for default risk. In each of the three robustness checks, the two liquidity betas of junk bonds continue to exhibit a strong regime-switching pattern.
What is the economic significance of these findings? We claim that the evidence is consistent with a flight-to-quality phenomenon during stress periods whereby investors prefer more liquid and safer assets to less liquid and riskier ones when market liquidity deteriorates. This preference manifests as a higher liquidity risk premium, so that the sensitivity of returns to liquidity factors rises. We call it a “liquidity” risk premium and not a generalized risk premium, since we found that in the stress times we examine or identify in data, there is no such increase in the sensitivity of returns to traditional risk factors such as interest rates and default risk.
To summarize, junk corporate bond returns exhibit liquidity risk that has a significant conditional component during stress times for economy and markets, and this conditional pattern is consistent with investor preference for safer and more liquid instruments during such times.
Section 2 discusses related literature. Section 3 describes the data we employ. Sections 4 and 5 present results for our unconditional and conditional liquidity risk tests, respectively. Section 5.1 shows the regime-switching model estimates. Section 5.2 considers robustness checks and Section 6 provides an application of liquidity risk to bond returns around rating downgrades. Finally, Section 7 provides a flight-to-quality based interpretation for our results. Section 8 concludes.
