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Endogenous liquidity and defaultable bonds


  • Konstantin Milbradt


  • Zhiguo He

    (University of Chicago)


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.

Suggested Citation

  • Konstantin Milbradt & Zhiguo He, 2012. "Endogenous liquidity and defaultable bonds," 2012 Meeting Papers 86, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:86

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    References listed on IDEAS

    1. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in Asset Markets: Market Structure, Liquidity, and Welfare," American Economic Review, American Economic Association, vol. 97(2), pages 198-202, May.
    2. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    3. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    5. Anatoli Segura & Javier Suarez, 2011. "Dinamic Maturity Transformation," Working Papers wp2011_1105, CEMFI.
    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, June.
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    1. repec:cup:jfinqa:v:53:y:2018:i:01:p:243-268_00 is not listed on IDEAS
    2. repec:eee:jfinec:v:112:y:2014:i:2:p:164-189 is not listed on IDEAS
    3. De Pooter, Michiel & Martin, Robert F. & Pruitt, Seth, 2018. "The Liquidity Effects of Official Bond Market Intervention," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(01), pages 243-268, February.

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