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Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle

Author

Listed:
  • Hui Chen
  • Rui Cui
  • Zhiguo He
  • Konstantin Milbradt

Abstract

We develop a structural credit risk model to examine how the interactions of liquidity and default risk affect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized financing, our model generates rich links between liquidity risk and default risk. The introduction of macroeconomic risks helps the model capture realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, our calibrated model can simultaneously match the average default probabilities, credit spreads, and bond liquidity measures including Bond-CDS spreads and bid-ask spreads in the data. Through a structural decomposition, we show that the interactions between liquidity and default risk account for 25∼40% of the observed credit spreads and up to 55% of the credit spread changes over the business cycle. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market.

Suggested Citation

  • Hui Chen & Rui Cui & Zhiguo He & Konstantin Milbradt, 2014. "Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle," NBER Working Papers 20638, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20638
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    References listed on IDEAS

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    1. Hui Chen & Yu Xu & Jun Yang, 2012. "Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads," NBER Working Papers 18367, National Bureau of Economic Research, Inc.
    2. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    3. Jun Liu & Francis A. Longstaff & Ravit E. Mandell, 2006. "The Market Price of Risk in Interest Rate Swaps: The Roles of Default and Liquidity Risks," The Journal of Business, University of Chicago Press, vol. 79(5), pages 2337-2360, September.
    4. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, August.
    5. Jankowitsch, Rainer & Nagler, Florian & Subrahmanyam, Marti G., 2014. "The determinants of recovery rates in the US corporate bond market," Journal of Financial Economics, Elsevier, vol. 114(1), pages 155-177.
    6. Alexander David, 2008. "Inflation Uncertainty, Asset Valuations, and the Credit Spreads Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2487-2534, November.
    7. Roll, Richard, 1984. " A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market," Journal of Finance, American Finance Association, vol. 39(4), pages 1127-1139, September.
    8. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
    9. 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, June.
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    Citations

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    Cited by:

    1. Chris Kenyon & Mourad Berrahoui & Benjamin Poncet, 2017. "Counterparty Trading Limits Revisited:CSAs, IM, SwapAgent(r), from PFE to PFL," Papers 1710.03161, arXiv.org.
    2. Song Han & Hao Zhou, 2016. "Effects of Liquidity on the Non-Default Component of Corporate Yield Spreads: Evidence from Intraday Transactions Data," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(03), pages 1-49, September.
    3. Helberg, Stig & Lindset, Snorre, 2016. "Risk protection from risky collateral: Evidence from the euro bond market," Journal of Banking & Finance, Elsevier, vol. 70(C), pages 193-213.
    4. Anton Tsoy, 2016. "Liquidity and Prices in Decentralized Markets with Almost Public Information," 2016 Meeting Papers 8, Society for Economic Dynamics.
    5. Zhiguo He & Konstantin Milbradt, 2016. "Dynamic Debt Maturity," NBER Working Papers 21919, National Bureau of Economic Research, Inc.
    6. Abudy, Menachem Meni & Raviv, Alon, 2016. "How much can illiquidity affect corporate debt yield spread?," Journal of Financial Stability, Elsevier, vol. 25(C), pages 58-69.
    7. Roland Füss & Thomas Gehrig & Philipp B. Rindler, 2016. "Changing Risk Perception and the Time-Varying Price of Risk," Review of Finance, European Finance Association, vol. 20(4), pages 1549-1585.

    More about this item

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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