Liquidity Risk of Corporate Bond Returns: A Conditional Approach
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for International Finance and Regulation (CIFR); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
New York University - Stern School of Business
Sreedhar T. Bharath
Arizona State University - W.P. Carey School of Business
September 20, 2012
Journal of Financial Economics (JFE), Forthcoming
AFA 2012 Chicago Meetings Paper
We study the exposure of the U.S. corporate bond returns to liquidity shocks of stocks and treasury bonds over the period 1973-2007 in a regime switching model. In one regime, liquidity shocks have mostly insignificant effect on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008-2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again liquidity shocks play a special role in periods characterized by adverse economic conditions.
Number of Pages in PDF File: 73
Keywords: Credit Risk, Credit Spreads, Default, Recession, Flight To Liquidity, Liquidity Risk, Regime Switching Model
JEL Classification: G12, G13, G32, G33Accepted Paper Series
Date posted: May 20, 2010 ; Last revised: October 26, 2012
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