51 Pages Posted: 17 Mar 2010 Last revised: 3 Jan 2014
Date Written: January 3, 2014
I propose a friction measure of bond round-trip liquidity costs that is robust to outliers and accounts for the idiosyncratic information behind trading decisions. Particularly effective with investment-grade bonds, the proposed measure displays properties consistent with the credit risk puzzle. Using transactions from January 2004 to December 2011, I find that liquidity costs display a strong correlation with credit conditions and peaked during the subprime crisis. After controlling for equity volatility with high-frequency measures, liquidity costs explain a substantial fraction of the variation in the yield spreads of highly rated bonds, but become less important for speculative-grade bonds.
Keywords: liquidity, credit risk, realized volatility, stochastic friction, TRACE
JEL Classification: C11, G12
Suggested Citation: Suggested Citation