State-Varying Illiquidity Risk in Sovereign Bond Spreads
36 Pages Posted: 12 Jan 2016
Date Written: January 10, 2016
Illiquidity and default risk are determinants of bond spreads that models suggest vary across market states. But attempts to empirically identify the separate impact of these factors are affected by correlation between them. The Australian sovereign debt market, where the Australian government provided an explicit guarantee over semi-government debt, provides an environment in which to examine these separate factors. We find that illiquidity risk in sovereign spreads is conditional upon market states and is particularly important during periods of market stress, consistent with the notion of flights to liquidity. These flights to liquidity are substantially more prominent at the shorter end of the term structure, whereas volatility predominantly explains longer-maturity sovereign spreads. The term spread of sovereign yields is shown to be negatively related to illiquidity during periods of stress, indicating that theoretical models that incorporate flights to liquidity need to be expanded to include the impact of such flights on both the level and slope of yields.
Keywords: Illiquidity risk, yield spreads, sovereign debt, volatility
JEL Classification: E43, G12
Suggested Citation: Suggested Citation