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Endogenous Liquidity and Defaultable Bonds

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  • Zhiguo He
  • Konstantin Milbradt

Abstract

This paper studies the interaction between default and liquidity for 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 decisions interact with the endogenous secondary market liquidity via the rollover channel. A default‐liquidity loop arises: Assuming a relative illiquid secondary bond market in default, earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full interdependence between liquidity and default for credit spreads, our calibrated model can jointly match empirically observed credit spreads and liquidity measures of bonds across different rating classes.

Suggested Citation

  • Zhiguo He & Konstantin Milbradt, 2014. "Endogenous Liquidity and Defaultable Bonds," Econometrica, Econometric Society, vol. 82(4), pages 1443-1508, July.
    • Handle: RePEc:wly:emetrp:v:82:y:2014:i:4:p:1443-1508
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    File URL: http://hdl.handle.net/10.1111/ecta.2014.82.issue-4.x
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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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