Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market during Financial Crises

Abstract

We use a unique data-set to study liquidity effects in the US corporate bond market, covering more than 30,000 bonds. Our analysis explores time-series and cross-sectional aspects of corporate bond yield spreads, with the main focus being on the quanti fication of the impact of liquidity factors, while controlling for credit risk. Our time period starts in October 2004 when detailed transaction data from the Trade Reporting and Compliance Engine (TRACE) became available. In particular, we examine three diff erent regimes during our sample period, the GM/Ford crisis in 2005 when a segment of the corporate bond market was a ffected, the sub-prime crisis since mid-2007, which was much more pervasive across the corporate bond market, and the period in between, when market conditions were more normal. We employ a wide range of liquidity measures and fi nd in our time-series analysis that liquidity eff ects explain approximately one third of market-wide corporate yield spread changes, in general, and are even more pronounced during periods of crisis. In particular, the price dispersion measure proposed by Jankowitsch, Nashikkar and Subrahmanyam (2008) explains about half of the aggregate bond yield spread changes during the sub-prime crisis. Our data-set allows us to examine in greater detail liquidity e ffects in various segments of the market: financial sector fi rms which have been particularly aff ected by the crisis vs. industrial firms, investment grade vs. speculative grade bonds, and retail vs. institutional trades. In addition, our cross-sectional analysis shows that liquidity explains a large part of the variation in yield spreads across bonds, after accounting for credit risk. These results yield important insights regarding the liquidity drivers of corporate yield spreads, particularly during periods of crisis.