Realized Volatility, Liquidity, and Corporate Yield Spreads

Abstract:     
This study revisits the relative role of credit risk and illiquidity as determinants of corporate bond prices. Using TRACE transaction data from January 2003 to December 2008, I find that high-frequency firm equity volatility measures explain 40% of the variation of corporate yield spreads and as much as 52% of the variation in a multivariate context. In contrast, trading-based illiquidity measures such as the percentage of zero trading days, the friction measure used by Chen, Lesmond, and Wei (2007), and a new measure derived in this paper explain approximately an incremental 1% of the cross-sectional variation of yield spreads. Unlike other friction models, the proposed model includes firm-specific factors in the return generating process and relaxes the assumption of constant liquidity. As a result, liquidity cost estimates are lower and uncorrelated with corporate yield spreads. Overall, my findings suggest that credit risk is the main determinant of corporate yield spreads and that certain trading-based illiquidity measures actually capture credit risk.

Number of Pages in PDF File: 58

Keywords: liquidity, credit risk, realized volatility, stochastic friction, TRACE

JEL Classification: C11, G12

working papers series