Endogenous Liquidity and Defaultable Bonds

Abstract:     
This paper studies the interaction between fundamental and liquidity for 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 decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-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. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.

Number of Pages in PDF File: 62

Keywords: Positive Feedback, Fundamental and Liquidity, Over-The-Counter Market, Secondary Bond Market, Structural Models for Credit Risk, Transaction Cost for Corporate Bonds, Bid-Ask Spread

working papers series