Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations

85 Pages Posted: 2 Jun 2020 Last revised: 5 Oct 2021

See all articles by Botao Wu

Botao Wu

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

Date Written: April 1, 2020

Abstract

I employ the corporate bond liquidity premium to understand the important changes in corporate bond market liquidity from 2004 to 2019. I show that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, and develop a structural over-the-counter model to estimate the latent trading delays implied by the size of the liquidity premium. The estimation results suggest that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium to uncover the potential cause of dealers' unwillingness to provide liquidity. I show that Basel II.5, by introducing the stressed value-at-risk and incremental risk charges for credit products, contributed the most to increasing the liquidity premium out of all regulatory changes examined. The longer trading delays and the impact of regulations are consistent with practitioners' descriptions of the post-crisis market and corroborate the relevance of using the liquidity premium to understand corporate bond market liquidity.

Keywords: Corporate Bond, Liquidity Premium, Trading Delays, Basel II.5

JEL Classification: G10, G12, G18, G20

Suggested Citation

Wu, Botao, Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations (April 1, 2020). NYU Stern School of Business, Available at SSRN: https://ssrn.com/abstract=3613379 or http://dx.doi.org/10.2139/ssrn.3613379

Botao Wu (Contact Author)

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

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New York, NY 10012
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