A New Perspective on the Corporate Bond Liquidity Factor

Abstract

This study documents properties of market-wide corporate bond liquidity and demonstrates that liquidity risk is an important determinant of returns. In market downturns, transaction costs rise for sellers and fall for buyers. The negative relation between buyer and seller liquidity motivates a new across-measure liquidity factor that incorporates an asymmetric liquidity component. Shocks to market-wide liquidity explain a large fraction of bond return variation in the time series. Primarily driven by the asymmetric component, the liquidity factor attracts a cross-sectional risk premium that is robust to controls for credit, equity, and interest rate factors as well as the illiquidity level.

Keywords: Liquidity risk, Risk factors, Asset pricing, Corporate bonds

JEL Classification: G12, G14