Liquidity Risk of Corporate Bond Returns: A Conditional Approach

73 Pages Posted: 20 May 2010 Last revised: 26 Oct 2012

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Yakov Amihud

New York University - Stern School of Business

Sreedhar T. Bharath

Arizona State University - W.P. Carey School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: September 20, 2012

Abstract

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.

Keywords: Credit Risk, Credit Spreads, Default, Recession, Flight To Liquidity, Liquidity Risk, Regime Switching Model

JEL Classification: G12, G13, G32, G33

Suggested Citation

Acharya, Viral V. and Amihud, Yakov and Bharath, Sreedhar T., Liquidity Risk of Corporate Bond Returns: A Conditional Approach (September 20, 2012). Journal of Financial Economics (JFE), Forthcoming; AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1612287 or http://dx.doi.org/10.2139/ssrn.1612287

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Yakov Amihud

New York University - Stern School of Business ( email )

44 West 4th Street
Suite 9-190
New York, NY 10012-1126
United States
212-998-0720 (Phone)
212-995-4233 (Fax)

Sreedhar T. Bharath (Contact Author)

Arizona State University - W.P. Carey School of Business ( email )

400 E. Lemon Street
Tempe, AZ 85287
United States
347-256-8784 (Phone)

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