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Endogenous liquidity and defaultable bonds

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  • Konstantin Milbradt

    (MIT)

  • Zhiguo He

    (University of Chicago)

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    Abstract

    This paper studies the liquidity of defaultable corporate bonds that are traded in an over- the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default and investment decisions interact with the endogenous secondary market liquidity via the rollover channel. A default/investment-liquidity loop arises: Earlier endogenous default worsens a bond’s secondary market liquidity, which amplifies equity holders’ rollover losses, which in turn leads to earlier endogenous default. Thus, our model characterizes the full inter-dependence between liquidity premium and default premium in understanding credit spreads for corporate bonds. We also study the optimal maturity implied by the model, and an extension where worsening secondary market liquidity feeds back to endogenous under- investment.

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    File URL: http://www.economicdynamics.org/meetpapers/2012/paper_86.pdf
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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 86.

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    Date of creation: 2012
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    Handle: RePEc:red:sed012:86

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    1. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc.
    2. Long Chen & David A. Lesmond & Jason Wei, 2007. "Corporate Yield Spreads and Bond Liquidity," Journal of Finance, American Finance Association, vol. 62(1), pages 119-149, 02.
    3. Alessandro Beber & Michael W. Brandt & Kenneth A. Kavajecz, 2009. "Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market," Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 925-957, March.
    4. Anatoli Segura & Javier Suarez, 2011. "Dynamic Maturity Transforation," Working Papers wp2011_1105, CEMFI.
    5. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October.
    6. Green, Richard C. & Hollifield, Burton & Schurhoff, Norman, 2007. "Dealer intermediation and price behavior in the aftermarket for new bond issues," Journal of Financial Economics, Elsevier, vol. 86(3), pages 643-682, December.
    7. Amy K. Edwards & Lawrence E. Harris & Michael S. Piwowar, 2007. "Corporate Bond Market Transaction Costs and Transparency," Journal of Finance, American Finance Association, vol. 62(3), pages 1421-1451, 06.
    8. Ing-Haw Cheng & Konstantin Milbradt, 2012. "The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts," Review of Financial Studies, Society for Financial Studies, vol. 25(4), pages 1070-1110.
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