Insolvency or Liquidity Squeeze? Explaining Very Short-Term Corporate Yield Spreads

42 Pages Posted: 9 Jan 2003

See all articles by Daniel M. Covitz

Daniel M. Covitz

Board of Governors of the Federal Reserve System

Chris Downing

BlackRock

Date Written: October 2002

Abstract

In this paper, we first document some stylized facts about very short-term and long-term corporate yield spreads. We find that short-term spreads are sizable, and the correlations between many firms' short-term and long-term yield spreads are at times negative. We then develop a structural model that generates levels and correlations of short-term and long-term spreads that are more consistent with what we observe. The model allows for the possibility of payment delays when a firm's liquid asset position deteriorates. Payment delays generate sizable short-term debt spreads because the realized returns on short-term investments are very sensitive to an increase in the holding period. The presence of liquidity risk can also explain negative correlations between short- and long-term spreads because liquidity risk is imperfectly correlated with insolvency risk. Using firm-level data, we provide empirical evidence that liquid assets holdings help predict short-term spreads, but not long-term spreads.

Keywords: Yields, spreads, default, insolvency, liquidity

JEL Classification: E4, G1, G3

Suggested Citation

Covitz, Daniel M. and Downing, Christopher T., Insolvency or Liquidity Squeeze? Explaining Very Short-Term Corporate Yield Spreads (October 2002). Available at SSRN: https://ssrn.com/abstract=347321 or http://dx.doi.org/10.2139/ssrn.347321

Daniel M. Covitz

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-5267 (Phone)
202-452-5295 (Fax)

Christopher T. Downing (Contact Author)

BlackRock ( email )

400 Howard Street
San Francisco, CA 94105
United States

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