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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26304
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| Title: | Latent Liquidity and Corporate Bond Yield Spreads |
| Authors: | Nashikkar, Amrut
Subrahmanyam, Marti G.
Mahanti, Sriketan |
| Keywords: | Corporate Bonds
Credit Risk
Credit Default Swaps
Basis
Liquidity
Latent Liquidity |
| Issue Date: | 16-Nov-2007 |
| Series/Report no.: | FIN-07-013 |
| Abstract: | Recent research has shown that default risk accounts for only a part of
the total yield spread on risky corporate bonds relative to their
risk-less benchmarks. One candidate for the unexplained portion of the
spread is a premium for liquidity. We investigate this possibility by
relating the liquidity of corporate bonds, as measured by their ease of
market access, to the basis between the credit default swap (CDS) price
of the issuer and the par-equivalent corporate bond yield spread. The
ease of access of a bond is measured using a recently developed measure
called latent liquidity, which is defined as the weighted average
turnover of funds holding the bond, where the weights are their
fractional holdings of the bond. We find that bonds with higher latent
liquidity are more expensive relative to their CDS contracts, after
controlling for other realized measures of liquidity. Additionally, we
document the positive effects of liquidity in the CDS market on the
CDS-bond basis. We also find that several firm-level variables related
to credit risk negatively affect the basis, indicating that the CDS
price does not fully capture the credit risk of the bond. Furthermore,
we find that when default risk of a firm is high, its illiquid bonds are
more expensive. We also document that bond-level variables related to
features of the contract that may be related to credit risk, such as the
presence of covenants, have a negative impact on the CDS-bond basis.
These findings are consistent with limits to arbitrage between the CDS
and bond markets, due to the costs of “shorting” bonds. |
| URI: | http://hdl.handle.net/2451/26304 |
| Appears in Collections: | Finance Working Papers
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