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Insolvency or liquidity squeeze? Explaining very short-term corporate yield spreads

  • Dan Covitz
  • Chris Downing
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    In this paper, we first document some stylized facts about very short-term and long-term corporate yield spreads. We find that short-term spreads are sizable, and the correlations between many firms' short-term and long-term yield spreads are at times negative. We then develop a structural model that generates levels and correlations of short-term and long-term spreads that are more consistent with what we observe. The model allows for the possibility of payment delays when a firm's liquid asset position deteriorates. Payment delays generate sizable short-term debt spreads because the realized returns on short-term investments are very sensitive to an increase in the holding period. The presence of liquidity risk can also explain negative correlations between short- and long-term spreads because liquidity risk is imperfectly correlated with insolvency risk. Using firm-level data, we provide empirical evidence that liquid assets holdings help predict short-term spreads, but not long-term spreads.

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    File URL: http://www.federalreserve.gov/pubs/feds/2002/200245/200245pap.pdf
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-45.

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    Date of creation: 2002
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    Handle: RePEc:fip:fedgfe:2002-45
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    1. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
    2. Hayne E. Leland., 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Research Program in Finance Working Papers RPF-233, University of California at Berkeley.
    3. Longstaff, Francis A., 2000. "The term structure of very short-term rates: New evidence for the expectations hypothesis," Journal of Financial Economics, Elsevier, vol. 58(3), pages 397-415, December.
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    6. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    7. Anderson, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Labys, Paul, 2002. "Modeling and Forecasting Realized Volatility," Working Papers 02-12, Duke University, Department of Economics.
    8. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
    9. Fisher, Lawrence, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 625-27, July.
    10. Sarig, Oded & Warga, Arthur, 1989. " Some Empirical Estimates of the Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(5), pages 1351-60, December.
    11. Wara, A. & Welch, I., 1990. "Bondholder Losses In Leveraged Buyouts," Papers fb-_90-04, Columbia - Graduate School of Business.
    12. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    13. Andersen, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Ebens, Heiko, 2001. "The distribution of realized stock return volatility," Journal of Financial Economics, Elsevier, vol. 61(1), pages 43-76, July.
    14. Jean Helwege & Christopher M. Turner, 1999. "The Slope of the Credit Yield Curve for Speculative-Grade Issuers," Journal of Finance, American Finance Association, vol. 54(5), pages 1869-1884, October.
    15. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
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