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Latent Liquidity and Corporate Bond Yield Spreads

Amrut J. Nashikkar

New York University (NYU) - Department of Finance

Marti G. Subrahmanyam

New York University - Stern School of Business

November 2007

NYU Working Paper No. FIN-07-013

Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their riskless benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. Furthermore, we find that when default risk of a firm is high, its illiquid bonds are more expensive. We also document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the CDS-bond basis. These findings are consistent with limits to arbitrage between the CDS and bond markets, due to the costs of "shorting" bonds.

Number of Pages in PDF File: 49

Keywords: Corporate Bonds, Credit Risk, Credit Default Swaps, Basis, Liquidity, Latent Liquidity

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Date posted: November 3, 2008  

Suggested Citation

Nashikkar, Amrut J. and Subrahmanyam, Marti G., Latent Liquidity and Corporate Bond Yield Spreads (November 2007). NYU Working Paper No. FIN-07-013. Available at SSRN: http://ssrn.com/abstract=1293151

Contact Information

Amrut J. Nashikkar (Contact Author)
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
+1-212-998-0718 (Phone)
HOME PAGE: http://pages.stern.nyu.edu/~anashikk
Marti G. Subrahmanyam
New York University - Stern School of Business ( email )
Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)
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