Bond Default Matters in China: Evidence from Illiquidity Premium

Abstract

This paper studies how market-wide credit risk affects the liquidity pricing in the bond market. With the emerging wave of China's bond defaults, the illiquidity premium is observed only after the first bond default, and it becomes significantly larger with the rising market-wide credit risk. In the presence of the default risk, the illiquidity premium is more pronounced among the non-SOE bonds and low-rated bonds. Our evidence suggests that breaking the expectation of rigid redemption increases the effectiveness of price discovery in China's capital market. As liquidity concern starts to play a nontrivial role, bond default matters after all.

Keywords: Default events, credit spread, illiquidity premium, flight-to-liquidity

JEL Classification: G12, G14, G18