Liquidity of Corporate Bonds
40 Pages Posted: 25 Mar 2008 Last revised: 11 Sep 2009
Date Written: July 9, 2008
This paper examines the liquidity of corporate bonds and its asset-pricing implications using a novel measure of illiquidity based on the magnitude of transitory price movements. Using transaction-level data for a broad cross-section of corporate bonds from 2003 through 2007, we find the illiquidity in corporate bonds to be significant, substantially greater than what can be explained by bid-ask bounce, and closely linked to liquidity-related bond characteristics. More importantly, we find a strong commonality in the time variation of bond illiquidity, which rises sharply during market crises and reaches an all-time high during the recent sub-prime mortgage crisis. Monthly changes in this aggregate bond illiquidity are strongly related to changes in the CBOE VIX Index and lagged stock market returns. Examining its relation with bond pricing, we find that our measure of illiquidity explains the cross-sectional variation in average bond yield spreads with large economic significance.
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